THE 

ARTHUR  YOUNG 

ACCOUNTING 

COLLECTION 


Graduate  School  of 
Business  Administration 

Library  of  the 

University  of  California 

Los  Angeles 


MMnfr^UTHERN 

UNIVERSITY  OP  CALIFO*«!t 

LIBRARY 

LOS    ANGELES,  C, 


Library 
Graduate  Sc^ol  of  Business  Administration 

Un i  ~rr'  ' :/  of  California 
Los  Angeles  24,  California 


PRINCIPLES    OF   ACCOUNTING 


THE  MACMILLAN  COMPANY 

NEW  YORK    •    BOSTON   •    CHICAGO  •    DALLAS 
ATLANTA  •    SAN  FRANCISCO 

MACMILLAN  &  CO.,  LIMITED 

LONDON  •    BOMBAY   •    CALCUTTA 
MELBOURNE 

THE  MACMILLAN  CO.  OF  CANADA,  LTD. 

TORONTO 


PRINCIPLES   OF 
ACCOUNTING 


BY 
WILLIAM  ANDREW  PATON,  PH.D. 

Associate  Professor  of  Economics  in  the  University  of  Michigan 
AND 

RUSSELL  ALGER  STEVENSON,  PH.D. 

Associate  Professor  of  Accounting  in  the  University  of  Iowa 


Weto  ffotfc 

THE   MACMILLAN   COMPANY 
1920 

All  rights  reserved 


COPYRIGHT,  1918, 
3v  THE  MACMILLAN  COMPANY. 


Set  up  and  electrotyped.    Published  October,  1918. 


J.  8.  Gushing  Co.  —  Berwick  &  Smith  Co. 
Norwood,  Mass.,  U.S.A. 


• 


Bus.  Admin. 
library 

HF 

5625 

P27p 


PREFACE 


book  is  intended  primarily  as  a  text  for  general  account- 
ing courses  in  colleges  and  universities/)  It  may  also  be  of  interest 
to  other  readers  than  college  students  who  wish  to  understand 

^       the  fundamentals  of  accounting.     Although  new  books  are  now 

f\l        being  rapidly  added  to  the  list  of  general  treatises  on  the  subject 

tf)  the  authors  feel  that  no  apology  need  be  offered  for  the  appear- 
ance of  this  volume.  There  has  been  a  dearth  of  material  avail- 
able for  the  student  of  economics  who  desires  a  broad  training 

^  in  accounting  principles  as  a  part  of  a  general  equipment.  The 
texts  available  are,  for  the  most  part,  too  highly  professional 

\  and  specialized  for  this  purpose,  and  are  without  adequate*  refer- 
ence to  the  background  of  economic  principles  underlying  all 

oj'  commercial  transactions.  In  other  words,  although  there  are 
many  books  intended  for  the  business  man  and  professional 

^  accountant  there  are  few  works  on  accounting  which  even  pro- 
fess to  be  suited  to  the  needs  of  the  student  of  economics.  It  is 
the  aim  of  this  book  to  present  the  principles  of  the  subject  in 
such  a  way  as  to  meet  the  needs  of  the  general  student  as  well 
as  to  afford  the  proper  basis  for  specialized  work  in  professional 
accountancy. 

An  effort  has  been  made  to  develop  principles  without  dis~ 
cussing  the  details  of  specific  systems  of  bookkeeping  and  office 
methods.  This  procedure  implies  that  accounting  is  a  science 
dealing  with  logical  classifications  and  embracing  a  definite 
body  of  doctrine  which  can  be  developed  independently  of  mere 
clerical  routine.  Furthermore,  since  the  classroom  is  not  a 
laboratory  capable  of  reproducing  exact  business  conditions, 
and  since  bookkeeping  methods  are  constantly  changing,  a 
discussion  of  clerical  details  is  of  minor  importance  in  a  treatise 
on  principles.  Once  a  student  is  thoroughly  grounded  a  mastery 
of  the  technical  details  of  any  particular  system  of  accounts 
is  easily  attained.  On  the  other  hand,  the  important  general 


vi  PREFACE 

features  of  technique  have  been  sufficiently  discussed  and  illus- 
trated to  familiarize  the  student  with  the  fundamental  types  of 
books  and  working  papers  used  in  modern  practice. 

The  essential  characteristics  of  modern  business  organization 
and  finance  have  received  some  consideration  because  of  the 
close  relation  of  these  matters  to  accounting.  No  attempt  has 
been  made,  however,  to  treat  these  topics  elaborately  or  to  refer, 
for  illustration,  to  specific  legal  cases.  In  the  first  place  a  too 
full  discussion  of  such  subjects  tends  to  leave  the  student  with 
a  vague  impression  of  the  accounting  principles  involved.  In 
the  second  place  such  details  as  may  be  desired  can  be  introduced 
more  effectively  by  means  of  problems  and  illustrations  from 
current  practice  furnished  by  the  instructor.  Further,  special 
courses  in  commercial  law,  business  organization,  corporation 
finance,  and  similar  subjects  are  generally  conceded  to  be  an 
essential  part  of  the  course  of  study  which  should  be  prescribed 
for  the  student  of  economics  and  accounting.  Accordingly, 
although  it  should  be  admitted  that  the  professional  accountant 
requires  a  rather  minute  knowledge  of  these  matters,  it  seems 
evident  that  a  lengthy  study  of  such  topics  cannot  properly  be 
included  in  a  single  course  in  accounting  principles. 

Although  in  the  exposition  of  principles  in  the  main  part  of 
the  book  special  systems  of  accounts  are  not  discussed,  it  has 
seemed  advisable  in  Part  Six  to  present  a  brief  statement  sug- 
gesting some  of  the  essential  features  of  the  more  important 
special  fields.  The  topics  considered  have  been  chosen  partic- 
ularly because  of  the  fact  that  in  many  institutions  the  ad- 
vanced courses  in  accounting  deal  with  these  branches  of  the 
subject.  Part  Six,  then,  serves  to  give  to  the  student  who  wishes 
to  pursue  special  work  a  glimpse  of  the  more  important  fields, 
and  also  serves  to  give  to  the  general  student  some  impression 
of  the  scope  of  accounting.  No  mention  is  made,  however,  of 
the  special  systems  required  by  banks,  insurance  companies, 
commission  merchants,  brokerage  houses,  farm  enterprises, 
construction  companies,  etc.  It  would  be  out  of  the  question 
to  include  a  study  of  many  special  systems  in  a  single  volume, 
and  in  any  case  it  is  doubtful  if  such  material  is  of  much  value 
to  the  student  of  general  accounting. 

Certain  rather  important  special  features  of  this  book  should, 


PREFACE  vii 

perhaps,  be  mentioned  in  the  foreword.  In  the  first  place  it 
has  seemed  to  the  authors  that  the  importance  of  the  proprietary 
interest,  so-called,  is  unduly  stressed  in  most  textbooks.  Indeed, 
the  usual  treatment  of  the  subject  is  so  dominated  by  the  doc- 
trines of  proprietorship  that  it  might  well  be  described  as  "pro- 
prietary accounting."  Although  this  theory  of  accounts  is 
not  an  unreasonable  view  for  the  accountant  who  is  dealing 
with  very  simple  situations,  as  applied  to  the  complex  conditions 
of  modern  business  organization  it  becomes  practically  untenable. 
Particularly  in  view  of  the  present  and  growing  importance  of 
the  corporate  form  of  organization,  with  all  its  complexities  of 
ownership,  is  it  becoming  more  difficult  to  define  proprietorship 
on  any  but  a  conventional  basis.  Accordingly,  the  significance 
of  the  concept  of  proprietorship  in  the  theory  of  accounts  has  been 
minimized  in  this  book  (although  the  accounting  importance  of 
this,  equity  has  by  no  means  been  neglected).  The  business 
enterprise  in  its  entirety  has  been  emphasized  as  the  accounting 
unit  of  organization,  and  an  attempt  has  been  made  to  state 
the  theory  of  accounts  in  terms  of  the  needs  and  purposes  of  all 
the  equities  in  the  enterprise  rather  than  from  the  standpoint 
of  any  particular  interest.  The  adoption  of  this  view  has  lead 
to  certain  important  consequences  in  connection  with  the  dis- 
cussion of  interest  transactions  and  other  topics. 

In  the  presentation  of  the  theory  of  valuation  this  book  also 
diverges  somewhat  from  current  treatments  of  the  subject.  A 
logical  theory  of  valuation  for  accounting  purposes  has  been 
adopted ;  and  for  the  sake  of  completeness  and  consistency  this 
view  has  been  introduced  even  in  the  discussion  of  the  elementary 
principles  of  double-entry.  It  is  possible  and  even  advisable, 
however,  for  the  instructor  to  postpone  the  consideration  of  the 
more  difficult  points  implicit  in  this  matter  until  they  are 
specifically  taken  up  later  in  the  text.  Further,  it  should  be 
emphasized  that  the  authors  recognize  that  there  are  certain 
practical  difficulties  in  the  way  of  the  actual  adoption,  at  all 
points,  of  some  of  the  theories  presented.  It  is  felt,  however, 
that  the  student  of  accounting  should  be  trained  in  the  logical 
analysis  of  business  situations,  and  that  such  training  will  pro- 
mote rather  than  jeopardize  his  chances  for  professional  success. 

The  discussion  of  the  interest  problem  in  this  volume,  partic- 


viii  PREFACE 

ularly  the  mathematics  of  interest,  is  rather  elaborate.  It  is 
recognized  that  the  mathematics  of  interest  calculation  is  a 
matter  somewhat  outside  the  field  of  accounting  proper.  Never- 
theless the  importance  of  this  subject,  particularly  in  connection 
with  certain  branches  of  accounting,  can  hardly  be  overem- 
phasized ;  and  there  can  be  no  doubt  that  it  should  form  a  part 
of  the  regular  course  of  study  taken  by  the  accounting  student. 
Moreover  in  many  cases  suitable  courses  in  mathematics  are 
not  available  to  supply  this  need.  Even  if  such  special  courses 
are  available  some  review  of  (or  introduction  to)  this  work  in 
connection  with  a  study  of  accounting  principles  seems  advisable. 
The  instructor,  however,  who  for  any  reason  desires  to  abbre- 
viate this  part  of  the  course  may  easily  do  so.  Chapter  XV  is 
designed  to  give  a  general  view  of  the  interest  problem  and  might 
be  used,  if  a  short  course  is  desired,  without  Chapters  XVI, 
XVII,  and  XVIII.  Or  Chapter  XVI  alone  might  be  omitted 
without  seriously  impairing  the  availability  of  the  remaining 
chapters. 

Finally,  the  terminology  employed  in  this  text  does  not  con- 
form to  current  business  and  accounting  usage  at  all  points. 
Since  this  is  primarily  a  book  for  the  student  it  has  seemed  legiti- 
mate for  the  sake  of  clearness  to  employ  some  terms  which 
differ  from  those  in  common  use.  Where  the  expressions  used 
here  differ  noticeably  from  current  practice,  however,  the  con- 
ventional terminology  is  referred  to.  An  attempt  has  been  made 
to  standardize  the  nomenclature  for  ajl  important  conceptions. 
A  serious  cause  of  confusion  in  accounting  is  the  loose  terminology 
commonly  employed.  To  some  extent  the  terms  adopted 
by  the  Interstate  Commerce  Commission  in  its  prescribed  classi- 
fications (which  represent  the  most  logical  system  of  accounting 
phraseology  at  present  developed)  have  been  used. 

This  book  has  been  planned  to  suit  the  needs  of  the  general 
course  in  principles  as  was  stated  above ;  and  it  is  believed 
that  it  can  be  used  successfully  in  either  one-year  or  two-year 
courses.  In  many  institutions  a  single  course  (running  from 
three  to  five  hours  per  week  through  two  semesters)  is  devoted 
to  the  study  of  principles.  In  such  a  course,  Part  One,  supple- 
mented by  laboratory  work,  will  furnish  sufficient  material  for 
the  first  semester's  work.  In  the  second  semester  the  student 


PREFACE  ix 

is  able  to  handle  larger  reading  assignments  in  the  advanced 
topics,  and  the  remaining  chapters  may  be  conveniently  covered. 
Where  a  two-year  course  of  from  two  to  three  hours  per  week  is 
given,  this  text  may  still  be  used  to  advantage  if  supplemented 
with  considerable  practice  work  in  elementary  accounting.  In 
any  case,  of  course,  practice  work  is  necessary.  The  authors 
have  prepared  a  book  containing  about  500  problems  and  exer- 
cises arranged  in  chapters  specifically  to  accompany  this  text.1  It 
is  probable  that  many  instructors  would  consider  it  unnecessary, 
if  using  this  exercise  book,  to  introduce  other  laboratory  material. 

The  authors  wish,  in  conclusion,  to  acknowledge  their  indebted- 
ness to  their  instructors  and  colleagues  (former  and  present)  of 
the  University  of  Michigan  who  have  furnished,  in  large  meas- 
ure, the  background  of  economics  and  accounting  which  has 
made  possible  the  preparation  of  this  text.  Among  these 
should  be  mentioned,  as  having  had  a  particularly  important 
influence,  Professor  H.  C.  Adams,  Professor  F.  M.  Taylor,  and 
Professor  David  Friday. 

A  special  acknowledgment  is  due  to  Professor  Friday  for 
suggestions  which  were  used  in  the  preparation  of  Chapter  I, 
and  to  Professor  W.  D.  Moriarty  of  the  University  of  Michigan 
for  reading  the  manuscript. 

W.  A.  P. 

R.  A.  S. 

SEPTEMBER  i,  1918. 


1  Published  by  George  Wahr,  Ann  Arbor,  Michigan. 


CONTENTS 

INTRODUCTION 

I 

PAGE 

THE  NATURE  AND  SCOPE  OF  ACCOUNTING         ....  3-13 

THE  BUSINESS  ENTERPRISE 3 

THE  NEED  FOR  ACCOUNTING  ANALYSIS         ....  7 

THE  GENERAL  PROBLEMS  OF  ACCOUNTING     .  IO 

PART  ONE 
ELEMENTS  OF  ACCOUNTING 

II 

THE  THEORY  OF  BALANCE  SHEET  ACCOUNTS     ....  17-34 

THE  FUNDAMENTAL  CLASSES  OF  DATA 17 

THE  ACCOUNTING  EQUATION 2O 

THE  CONSTRUCTION  OF  ACCOUNTS 24 

CLASSES  OF  TRANSACTIONS 29 

DOUBLE-ENTRY  —  DEBIT  AND  CREDIT 31 

III 

TEE  CONSTRUCTION  OF  SUPPLEMENTARY  ACCOUNTS  .        .        .  35-5  5 

CURRENT  ASSET  ACCOUNTS 35 

EXPENSE  AND  REVENUE  ACCOUNTS        .        .        .        .        .  39 

SPECIAL  EQUITY  ACCOUNTS 43 

VALUATION  ACCOUNTS 47 

THE  CLASSIFICATION  OF  ACCOUNTS 5° 

IV 

THE  ANALYSIS  AND  RECORDING  OF  TRANSACTIONS    .        .        .  56-76 

THE  BOOKS  OF  RECORD  AND  ACCOUNT          ....  56 

xi 


xii  CONTENTS 

PACE 

THE  JOURNAL 59 

THE  LEDGER 62 

JOURNALIZING 64 

POSTING 75 


DEVELOPMENTS  IN  TECHNIQUE 77-102 

THE  SPECIAL-COLUMN  JOURNAL 77 

THE  CASH  BOOK 85 

THE  SALES  BOOK QO 

THE  PURCHASE  BOOK     .        .        .        .        .        .        .        .  Q2 

THE  VOUCHERS  PAYABLE  REGISTER 93 

SPECIALIZED  LEDGERS 96 

VI 

THE  ASSET  ACCOUNTS 103-131 

ACCOUNTS  WITH  FIXED  TANGIBLES 103 

ACCOUNTS  WITH  FIXED  INTANGIBLES IIO 

FUNCTIONAL  CLASSIFICATION  OF  FIXED  ASSET  ACCOUNTS      .  117 

ACCOUNTS  WITH  CURRENT  TANGIBLE  ASSETS         .        .        .  I2O 

ACCOUNTS  WITH  CURRENT  RIGHTS 126 

VII 

FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS        .        .        .    132-150 

ACCOUNTS  WITH  FIXED  EQUITIES 132 

CLASSES  OF  EXPENSE  AND  REVENUE  ACCOUNTS    .        .        .  136 

NET  REVENUE  AND  SURPLUS  ACCOUNTS        ....  143 

ACCOUNTS  WITH  CURRENT  LIABILITIES          ....  147 

VIII 

CLOSING  AND  INTERPRETING  THE  ACCOUNTS      ....    151-191 

THE  TRIAL  BALANCE 151 

THE  NECESSITY  FOR  THE  INVENTORY  AND  APPRAISAL  .        .  154 

CLOSING  ACCOUNTS  WITH  FIXED  ASSETS        .        .        .        .  157 

MATERIALS,  SALES  AND  SUBSIDIARY  ACCOUNTS      .        .        .  160 

CLOSING  MERCHANDISE  ACCOUNTS 167 

CLOSING  ACCOUNTS  RECEIVABLE    ......  174 

CLOSING  OTHER  CURRENT  ACCOUNTS 177 

SUMMARY  ACCOUNTS  FOR  SUNDRY  ASSETS  AND  LIABILITIES  182 


CONTENTS 


Kill 


CLOSING  THE   EXPENSE  AND   REVENUE  ACCOUNTS 
CLOSING   THE   NET  REVENUE  AND   EQUITY  ACCOUNTS 

IX 

THE  PREPARATION  OF  STATEMENTS     .... 
THE  EXPENSE  AND  REVENUE  STATEMENT 
THE  NET  REVENUE  AND  SURPLUS  STATEMENT 

THE  BALANCE  SHEET 

THE  TEN-COLUMN  STATEMENT 

THE  WORKING  SHEET 

X 

THE  DETERMINATION  OF  NET  REVENUE    . 
THE  SIGNIFICANCE  OF  NET  REVENUE    . 

THE  CASH  STATEMENT 

DEFERRED  CHARGES  AND  CREDITS 

WASTING  ASSETS 

MAINTENANCE  AND  IMPROVEMENT 
APPRECIATION  AND  DEPRECIATION 


PAGE 

184 
I87 


192-219 

193 
197 
2OI 
207 
215 


22O-243 
2  2O 
224 
228 
232 

234 
238 


PART  TWO 
THE  EQUITY  ACCOUNTS 

XI 

PROPRIETORSHIP  —  SINGLE-PROPRIETORS'  AND  PARTNERS'  AC- 
COUNTS      247-268 

PROPRIETORSHIP 247 

THE  SINGLE-PROPRIETOR  ENTERPRISE 250 

COPARTNERSHIP  PROPRIETARY  ACCOUNTS       .        .        .        .  2$5 

SPECIAL  PROBLEMS  IN  PARTNERSHIP  ACCOUNTING         .        .  260 

XII 

CORPORATE  PROPRIETORSHIP  —  CAPITAL  STOCK         .        .        .    269-293 

CORPORATE  PROPRIETORSHIP 269 

THE  TRANSITION  FROM  PARTNERSHIP  TO  CORPORATION         .  276 

ORGANIZATION  —  STOCK  ISSUED  FOR  CASH    ....  280 

DONATED  AND  TREASURY  STOCK 285 

SUBSIDIARY  PROPRIETARY  RECORDS       .....  290 


xiv  CONTENTS 

XIII 

PAGE 

CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  .       .       .  294-312 

CAPITAL  SURPLUS  AND  DEFICIT 294 

ACCUMULATED  PROFIT  AND  LOSS 297 

DIVIDEND  APPROPRIATIONS 300 

SINKING  FUND  APPROPRIATIONS 305 

MISCELLANEOUS     SURPLUS     TRANSACTIONS     AND     APPRO- 
PRIATIONS        308 

XIV 

THE  LIABILITIES 313-327 

ACCOUNTS  AND  NOTES  PAYABLE 313 

ACCRUED,  DEFERRED  AND  CONTINGENT  LIABILITIES      .        .  318 

MORTGAGES  AND  BONDS 322 


PART  THREE 
THE  INTEREST  PROBLEM 

XV 

A  GENERAL  ANALYSIS  OF  THE  INTEREST  PROBLEM   .        .        .    331-348 

THE  INTEREST  PHENOMENON 331 

COMMERCIAL  INTEREST 334 

LONG-TERM   SECURITIES 339 

INTEREST  IN  VALUATIONS 344 

XVI 

INTEREST  CALCULATIONS 349-386 

THE  ACCUMULATION  OF  PRINCIPAL 349 

THE  PRESENT  VALUE  OF  A  FUTURE  SUM      .       .       .       .  355 

THE  ACCUMULATION  OF  AN  ANNUITY 360 

PRESENT  WORTH  OF  AN  ANNUITY 365 

SINKING  FUND  CONTRIBUTIONS 372 

THE  ANNUITY  WHICH  A  PRINCIPAL  WILL  PURCHASE     .  374 

THE  APPORTIONMENT  OF  ANNUITY  PAYMENTS        .        .        .  376 

THE  VALUATION  OF  BONDS .  378 

ACCUMULATION  AND  AMORTIZATION 381 

DETERMINING  THE  INTEREST  RATE 383 


CONTENTS  XV 
XVII 

PAGE 

INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS  ....  387-411 

LONG-TERM  NON-INTEREST  BEARING  NOTES  ....  387 

ANNUITIES 391 

BONDS  ISSUED  AT  PAR 395 

BONDS  ISSUED  AT  A  DISCOUNT 4OI 

BONDS  ISSUED  AT  A  PREMIUM 405 

THE  REFUNDING  OF  SECURITIES 409 

XVIII 

INTEREST  TRANSACTIONS  —  ASSET  ACCOUNTS     ....  412-429 

INVESTMENTS  IN  SECURITIES         .       .       .               .       .  412 

INTEREST  IN  FIDUCIARY  ACCOUNTING 421 

SINKING  FUNDS     .       .       .       . 425 


PART  FOUR 
THE  VALUATION  OF  ASSETS 

XIX 

ORGANIZATION  AND  CONSTRUCTION 433-450 

ORGANIZATION  COSTS 433 

DEPRECIATION  DURING  CONSTRUCTION  .        .        .              "  .  436 
INTEREST,    DIVIDEND   AND   TAX   ACCRUALS    DURING    CON- 
STRUCTION        438 

THE  CONSTRUCTION  PERIOD  —  ILLEGITIMATE  COSTS       .       .  446 

DISCOUNTS  ON  SECURITIES 448 

XX 

THE  BASIS  FOR  REVALUATION 451-469  , 

THE  GENERAL  SIGNIFICANCE  OF  VALUE  CHANGES      '    .        .  451 

VALUATION  AND  MANAGEMENT 455 

THE  MEASUREMENT  OF  INVESTMENT  OR  SACRIFICE       .       .  461 
SPECIAL   OBJECTIONS   TO   THE   RECOGNITION   OF    APPRECI- 
ATION         463 

XXI 

THE  VALUATION  OF  SPECIAL  ASSETS 470-481 

CASH  AND  RECEIVABLES  47° 


xvi  CONTENTS 

PACK 

MERCHANDISE  AND   GOODS  IN  PROCESS 474 

MACHINERY,   BUILDINGS  AND   LAND 477 

XXII 

THE  DEPRECIATION  ACCOUNTS 482-505 

THE  DEPRECIATION  PROBLEM 482 

REPAIRS  AND  RENEWALS 485 

THE  REPLACEMENT  POLICY 488 

FORMAL  DEPRECIATION  ACCOUNTS 49 1 

THE  DEPRECIATION  FUND 496 

DEPRECIATION  FUND  RETURNED  TO  INVESTORS     ...  500 

THE  POLICY  OF  REINVESTING  THE  FUND  IN  THE  BUSINESS  503 

XXIII 

METHODS  OF  MEASURING  DEPRECIATION 506-527 

THE  BASIS  FOR  MEASUREMENT 506 

STRAIGHT  LINE  METHOD 511 

THE  SINKING  FUND  METHOD 515 

THE  COMPOUND  INTEREST  METHOD 517 

PRESENT  VALUE  OF  FUTURE  REVENUE  METHOD    .        .        .  520 

MISCELLANEOUS  METHODS 524 

XXIV 

THE  INTANGIBLE  ASSETS     .        .        .        .        .        .        .        .    528-541 

THE  NATURE  OF  GOODWILL 528 

THE  VALUATION  OF  GOODWILL 530 

GOING  VALUE 535 

MISCELLANEOUS  INTANGIBLES 538 


PART  FIVE 

THE  CONSTRUCTION  AND  ANALYSIS  OF  FINANCIAL 
STATEMENTS 

XXV 

THE  INCOME  SHEET 545-571 

PURPOSES  OF  INCOME  SHEETS 546 

SUMMARY  INCOME  SHEETS 549 


CONTENTS 


xvii 


THE  COMPARATIVE   INCOME   SHEET 
SOME   SPECIAL   FORMS   OF   INCOME   SHEETS 
FURTHER  CLASSIFICATION   OF   OPERATING  ACCOUNTS 
THE   CONSOLIDATED   INCOME    SHEET 

XXVI 

THE  GENERAL  BALANCE  SHEET          .... 
GENERAL  BALANCE  SHEET  CAPTIONS     . 
ILLUSTRATIVE  BALANCE  SHEETS    .... 
CLASSIFICATION  OF  ASSET  ACCOUNTS     . 

XXVII 

COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS 
THE  COMPARATIVE  BALANCE  SHEET 
THE  CONSOLIDATED  BALANCE  SHEET 


555 
558 
563 
567 


572-586 
572 
576 

584 


587-598 
587 
592 


STATEMENTS  OF  INSOLVENCY 
STATEMENT  OF  AFFAIRS 
DEFICIENCY  STATEMENT  . 


XXVIII 


599-605 

599 
603 


PART  SIX 
SPECIAL  FIELDS  OF  ACCOUNTING 

XXIX 

COST  ACCOUNTING 

THE  PROBLEMS  OF  MANAGEMENT 

THE  CLASSIFICATION  AND  DISTRIBUTION  OF  EXPENSE   . 


609-619 
609 
615 


XXX 


MUNICIPAL  ACCOUNTING 

THE  MUNICIPAL  BALANCE  SHEET 
THE  MUNICIPAL  INCOME  SHEET 
THE  MUNICIPAL  BUDGET 


620-628 
621 
623 
626 


xviii  CONTENTS 

XXXI 

PAGE 

RAILROAD  ACCOUNTING 620-641 

THE  I.  C.  C.  CLASSIFICATIONS 629 

RATE  REGULATION  AND  ACCOUNTING 638 

XXXII 

AUDITING 642-649 

THE  PURPOSES  OF  AUDITS 642 

THE  ESSENTIALS  OF  AUDITING 646 


APPENDICES 

A 

THE  TREATMENT  OF  CASH  DISCOUNTS 653-656 

B 
INTEREST  TABLES 657-667 

C 

RAILWAY  STATEMENTS         .       .       .       .    *   .       .       .        .    668-674 

D 

SELECTED  BIBLIOGRAPHY 675-676 

INDEX 677-685 


INTRODUCTION 


PRINCIPLES  OF  ACCOUNTING 


THE  NATURE  AND  SCOPE  OF  ACCOUNTING 

ACCOUNTING,  in  a  broad  sense,  is  the  science  which  attempts  to 
present  and  classify  the  statistics  of  the  properties  and  property 
rights  in  the  business  enterprise.  All  valuable  considerations 
coming  into  the  possession  of  a  business  concern  should  be  ac- 
counted for,  and  the  rights  which  various  individuals  and 
interests  have  in  the  business  must  be  protected.  To  accomplish 
this,  more  or  less  elaborate  statistical  records  are  usually  neces- 
sary. 

Since  accounting  has  to  do  primarily  with  the  private  business 
enterprise,  the  gaining  of  a  general  conception  of  the  enterprise  as 
the  accounting  unit  of  organization  is  an  essential  preliminary 
step  in  the  study  of  this  subject.  In  the  following  section  the 
nature  of  the  business  enterprise  will  accordingly  be  briefly 
discussed. 

THE  BUSINESS   ENTERPRISE 

A  business  enterprise  involves  the  investment  of  capital 
funds,  often  by  more  than  one  individual,  in  some  commercial 
project.  Such  a  venture,  supposedly,  contemplates  the  pro- 
duction of  some  commodity  or  service  which  commands  a  price 
on  the  market.  The  owners  of  the  capital  invested  in  any  case 
naturally  expect  to  realize  a  gross  income  from  the  sales  of  the 
product  which  will  not  only  maintain  the  original  investment 
but  will  yield  a  net  income  as  well.  It  is  the  function  of  account- 

3 


4  PRINCIPLES  OF  ACCOUNTING 

ing  to  follow  the  investment,  as  it  takes  shape  in  various  com- 
modities and  services,  and  to  inform  the  investor  as  to  the 
amount  and  rate  of  net  income  and  the  subsidiary  facts  which 
will  enable  him  to  make  a  rational  disposition  of  his  resources. 

The  familiar  types  of  business  organization  in  the  United 
States  are  the  single-proprietorship,  the  partnership,  and  the 
corporation.  The  joint  stock  company,  a  kind  of  halfway 
house  between  the  partnership  and  the  corporation,  is  no  longer 
common  in  this  country,  having  been  almost  entirely  superseded 
by  the  corporation.  A  brief  statement  of  the  nature  of  these 
three  common  types  of  business  units  will  be  given  at  this  point. 

The  single-proprietorship  is  a  business  enterprise  conducted 
by  a  single  individual.  Actual  ownership  of  the  property  used 
commonly  resides  largely  in  the  hands  of  the  proprietor,  so- 
called.  The  proprietor  is  usually  the  active  manager  of  the 
business  and  may  furnish  a  considerable  part  of  the  ordinary 
labor  services  required. 

In  a  strict  sense  any  capitalist,  however  humble,  who  is  utilizing 
his  resources  in  an  independent  commercial  venture,  is  a  pro- 
prietor, and  his  business  is  a  single-proprietorship.  The  majority 
of  retail  stores  are  of  this  type,  many  wholesale  and  manufactur- 
ing businesses  are  single-proprietorships,  and  farm  establish- 
ments are  almost  always  in  this  class.  Such  enterprises  range  in 
importance  from  the  fruit  stand  on  the  corner  to  the  private 
banking  house  or  other  large  business  having  an  investment  of 
many  thousands  of  dollars.  Very  large  aggregates  of  capital, 
however,  are  seldom  brought  together  under  the  single-proprie- 
torship form. 

Although  the  single-proprietorship  is  legally  only  a  kind  of 
personal  enterprise,  and  no  formal  steps  of  organization  are 
usually  required  for  its  initiation,  still  it  is  useful  for  the 
accountant  to  conceive  of  such  a  business  as  a  commercial  unit 
of  organization.  The  personification  of  the  business  enterprise, 
a  figure  so  much  deplored  by  some  writers,  is  one  of  the  funda- 
mental ideas  of  accounting,  and  it  may  well  be  applied  to  all 
kinds  of  businesses,  the  simple  as  well  as  the  complex.  In  gen- 
eral this  view  conforms  to  commercial  and  legal  practice  and  no 
apologies  need  be  made  for  such  a  conception.  The  most  im- 
portant financial  statement,  the  balance  sheet,  can  always  be 


NATURE  AND  SCOPE  5 

conveniently  conceived  as  representing  the  financial  condition 
of  a  distinct  business  entity. 

Probably  the  great  majority  of  single-proprietors  make  but 
an  imperfect  use  of  accounts ;  but  something  in  the  way  of 
statistical  records  is  essential  in  nearly  all  such  cases,  and 
efficiency  in  the  management  of  even  the  small  concern  would 
generally  be  much  advanced  by  an  extension  of  the  use  of 
systematic  accounting  methods.  Certainly  the  accountant 
should  be  familiar  with  the  general  nature  of  the  single-pro- 
prietorship and  the  accounting  problems  arising  in  such  cases. 

The  partnership  is  an  association  of  two  or  more  persons  by 
contractual  agreement  in  a  business  undertaking.  Partnerships 
are  usually  composed  of  but  two,  three,  or  four  members,  but 
there  may  be  any  number  of  partners.  The  partnership  associa- 
tion is  usually  based  upon  a  written  agreement  called  the  articles 
of  copartnership.  This  agreement  commonly  contains  stipula- 
tions in  regard  to  investments,  withdrawals  of  principal  or  in- 
come, management,  division  of  income,  dissolution,  etc. 

It  is  fairly  evident  that  careful  accounting  is  much  more  im- 
portant in  the  case  of  the  partnership  than  in  the  case  of  the 
single-proprietorship.  Where  more  than  one  individual  or  interest 
is  involved  in  an  enterprise  questions  of  equity  commonly  arise. 
The  failure  to  keep  a  careful  record  of  all  business  transactions 
in  such  a  case  may  result  in  the  exploitation  of  one  equity  to  the 
advantage  of  another ;  and  at  any  rate  if  the  business  is  of  con- 
siderable size  and  complexity  the  partners  will  be  very  much  in 
the  dark  as  to  the  actual  situation.  The  importance  of  proper 
accounting  is  the  more  clearly  seen  when  it  is  noted  that  the 
rights  of  the  partners  in  control,  income,  investment,  etc.,  may 
differ  widely.  The  characteristics  of  the  partnership  and  the 
peculiarities  of  partnership  accounting  will  be  specifically  dis- 
cussed later  in  the  text. 

The  corporation  is  in  many  respects  the  most  important  form  of 
business  organization.  In  point  of  aggregate  capital  controlled, 
number  of  employees,  quantity  of  output,  financial  influence, 
etc.,  the  corporation  easily  leads  in  many  important  lines  of 
industry ;  and  the  development  of  this  form  of  organization  does 
not  yet  appear  to  have  reached  its  limit.  The  corporation  is 
marvelously  well  adapted  to  the  exigencies  of  large  scale  pro- 


6  PRINCIPLES  OF  ACCOUNTING 

duction.  By  this  device  the  capital  of  the  investor,  great  and 
small,  is  brought  together  and  welded  into  a  unit  for  purposes  of 
carrying  on  economic  production  under  modern  conditions.  By 
means  of  a  great  variety  of  securities  the  corporation  form  per- 
mits of  the  division  of  the  important  elements  of  ownership  in 
such  a  way  as  to  attract  all  classes  of  investors. 

The  corporation  like  the  partnership  is  an  association  of  indi- 
viduals and  interests  who  have  combined  their  funds  in  a  busi- 
ness undertaking  with  the  hope  of  ultimate  profit.  A  very 
important  feature  of  the  corporation  lies  in  the  fact  that  the 
fiction  of  the  business  enterprise  is  supported  in  this  case  by  the 
attitude  of  the  law  which  views  a  corporation  as  an  entity  sep- 
arate and  distinct  from  the  personnel  of  its  members.  Limited 
liability  and  other  important  consequences  follow  from  this 
view. 

The  members  proper  of  a  corporation  are  its  shareholders. 
The  interests  of  the  shareholders  in  the  joint  investment  are 
evidenced  by  formal  instruments  known  as  stock  certificates. 
The  total  of  the  capital  stock  outstanding  constitutes  the  formal 
expression  of  the  stockholders'  equity  in  the  business.  Outside 
interests,  known  as  the  creditors,  also  furnish  capital.  The 
bondholder  is  the  most  important  investor  of  this  class. 

The  modern  business  corporation  with  its  vast  aggregate  of 
property  and  its  complexity  of  property  rights,  furnishes  the 
more  difficult  problems  of  accounting  analysis.  In  the  next 
section  some  features  of  the  large  scale  enterprise  will  be  further 
emphasized. 

In  all  of  these  forms  of  business  organization  the  interests  of 
the  private  owners  are  uppermost.  It  is  the  private  investors 
who  largely  control  operation.  It  is  the  owners  or  their  em- 
ployees who  keep  the  accounts.  Consequently  the  influence  of 
the  private  equities  upon  accounting  concepts  and  methods  is 
predominating. 

The  ownership  of  economic  goods  is  not  restricted  to  what 
may  properly  be  called  the  business  enterprise.  The  owner  of 
a  residence  and  other  consumption  goods,  for  example,  may  have 
a  considerable  estate.  Semi-business  associations  with  a  con- 
siderable capital  investment  which  have  as  a  purpose  the  further- 
ing of  some  philanthropic  or  similar  end  are  also  common.  The 


NATURE  AND  SCOPE  7 

municipality  or  state  often  owns  large  aggregates  of  property. 
A  communistic  community  may  own  property  devoted  to  both 
consumptive  and  productive  purposes.  In  these  cases,  however, 
while  it  is  possible  and  usually  necessary  to  make  use  of  ac- 
counting records,  the  typical  problems  of  accounting  do  not  pre- 
sent themselves.  The  private  business  enterprise,  organized 
for  pecuniary  profit,  is  the  typical  accounting  unit,  and  the  dis- 
cussion of  accounting  principles  in  this  text  will  be  restricted 
primarily  to  a  consideration  of  the  problems  arising  in  connec- 
tion with  such  enterprises. 

THE  NEED  FOR  ACCOUNTING  ANALYSIS 

It  is  the  function  of  accounting,  then,  to  present  a  record  of  the 
various  properties  owned  by  the  business  enterprise  and  a  show- 
ing of  the  equities  in  the  enterprise.  The  importance  of  account- 
ing and  related  branches  of  statistical  science  in  modern  business 
can  be  emphasized  by  a  brief  consideration  of  some  general 
characteristics  of  large  scale  production  and  certain  other  aspects 
of  the  present  industrial  situation. 

In  the  first  place  the  mere  size  of  the  modern  business  unit 
should  be  stressed.  To-day  the  large  scale  enterprise,  operating 
a  huge  plant  and  selling  goods  in  a  world  market,  is  a  familiar 
fact.  One  of  the  most  important  influences  making  possible  this 
concentration  of  capital  has  been  the  tremendous  improvement 
in  transportation  facilities  and  the  consequent  extension  of  the 
market.  The  development  of  the  corporate  form  of  organization 
mentioned  above  is  another  important  factor  contributing  to  (or 
at  least  accompanying)  the  growth  of  large  scale  production. 
This  form  of  business  organization  makes  possible  the  bringing 
together  of  vast  aggregates  of  capital.  Some  large  corporations 
have  many  thousands  of  stockholders.  Evidently  mere  size 
and  complexity  of  organization  contribute  to  the  need  for  ex- 
tensive statistical  records. 

Closely  connected  with  the  large  size  of  the  modern  business 
unit  is  the  great  variety  of  property  types  used  in  production. 
The  production  of  transportation  service,  for  example,  involves 
the  use  of  many  kinds  of  property  such  as,  land,  bridges,  tunnels, 
rails,  ties,  buildings,  rolling  stock,  various  kinds  of  services,  etc. 


8  PRINCIPLES  OF  ACCOUNTING 

Similarly  in  manufacturing  and  other  industries  (in  fact  wherever 
large  scale  production  is  developed)  a  complex  equipment  is 
necessary.  This  complexity  of  property  bears  an  important  re- 
lation to  the  problem  of  financial  accounting.  The  heteroge- 
neous character  of  property  is  one  of  the  factors  which  necessitate 
the  use  of  value  units ;  e.g.,  it  is  impossible  to  add  railroad  tracks, 
buildings,  bridges,  etc.,  without  reducing  all  of  these  items  to  a 
common  denominator.  Further,  the  problem  of  ascertaining 
the  amount  of  property  expired  in  any  given  period  is  compli- 
cated by  the  great  variety  of  property  used. 

The  problem  of  valuation  is  rendered  still  more  difficult  by 
the  fluctuations  in  price  to  which  the  modern  market  is  sus- 
ceptible. In  a  static  economic  society  the  problem  of  ascertain- 
ing the  status  of  property  is  largely  physical.  Physical  units 
in  such  a  case  could  be  converted  directly  into  value  terms ;  for 
value  can  be  measured  in  terms  of  the  item  itself.  The  medieval 
shepherd,  for  example,  could  count  his  wealth  and  his  income  in 
sheep.  But  the  continual  fluctuations  in  the  level  of  prices, 
which  constitute  changes  in  the  measuring  unit  itself,  complicate 
the  process  of  valuation,  and  may  require  recognition  in  the 
statistical  records.  Indeed,  it  is  prices  under  the  present  system 
that  "render  possible  the  rational  direction  of  economic  activity 
by  accounting,  for  accounting  is  based  upon  the  principle  of  rep- 
resenting all  the  heterogeneous  commodities,  services,  and 
rights  with  which  a  business  enterprise  is  concerned  in  terms  of 
money  price."  1  The  point  should  be  emphasized  that  account- 
ing in  modern  times  deals  directly  and  primarily  with  the  value 
representations  of  things ;  the  use  of  physical  facts  in  ac- 
counting statistics  is  entirely  subordinate. 

Another  characteristic  of  modern  business  which  has  con- 
tributed to  the  present  emphasis  upon  accounting  is  the  special- 
ization of  securities  which  has  been  made  possible  by  the  develop- 
ment of  the  corporate  form  of  organization  as  was  stated  in  the 
preceding  section.  Not  only  do  many  individuals  contribute 
capital  to  this  type  of  enterprise,  but  their  rights  to  income 
and  property  vary  according  to  the  class  of  security  held.  To- 
day one  is  familiar  with  common  stock,  preferred  stock,  mort- 
gage bonds,  debenture  bonds,  income  bonds,  collateral  trust 

1  Mitchell,  Business  Cycles,  pp.  31-32. 


NATURE  AND  SCOPE  9 

notes,  etc. ;  and  some  of  these  classes  may  be  subdivided  almost 
indefinitely.  The  task  of  preserving  the  rights  between  the 
different  classes  of  security-holders  is  a  difficult  one,  and  cannot 
be  satisfactorily  accomplished  without  the  aid  of  information 
based  upon  extensive  statistical  data. 

A  striking  phenomenon  of  the  modern  industrial  process  is  its 
susceptibility  to  trade  disturbances.  While  the  severity  of  the 
business  cycle  has  been  due  in  a  measure  to  unsound  banking 
and  credit  institutions,  it  should  be  recognized  that  reforms  in 
this  direction  can  never  be  more  than  palliatives.  The  essential 
cause  of  the  business  cycle  is  the  difficulty  experienced  by  the 
entrepreneur,  and  the  business  world  generally  in  accurately 
forecasting  the  market  situation.  It  is  coming  to  be  recognized 
that  extensive  dissemination  of  complete  and  reliable  information 
concerning  the  entire  industrial  process  is  the  most  promising 
remedy  for  alleviating  this  condition.  The  data  concerning  the 
financial  situation  furnished  by  the  accounts  form  an  important 
part  of  the  information  necessary  for  the  construction  of  a  trade 
barometer. 

The  present  tendency  toward  public  control  and  regulation 
of  industry  is  another  factor  which  emphasizes  the  need  for 
accounting  analysis.  The  public  has  awakened  to  the  need  for 
controlling  the  activities  of  the  entrepreneur  when  the  interests 
of  the  individual  conflict  with  those  of  society.  Further,  the 
complexity  of  the  private  equities  involved  renders  more  em- 
phatic the  need  for  government  interference.  The  public  can 
pass  sound  judgments  on  the  complex  situations  that  arise  only 
on  the  basis  of  reliable  statistical  information. 

Much  emphasis  is  being  placed  at  present  upon  the  necessity 
for  internal  economy  of  organization  in  industrial  enterprises. 
There  are  several  causes  for  this  situation.  First  may  be  men- 
tioned the  fact  that  the  opportunities  to  increase  revenues  through 
the  exploitation  of  undeveloped  natural  resources  is  largely  past. 
In  addition  to  this,  the  technique  of  industry,  which  has  under- 
gone tremendous  development  in  the  past  century  and  a  half, 
is  becoming  standardized  ;  this  means  that  the  opportunities  for 
building  large  fortunes  through  the  development  of  inventions 
are  more  restricted  than  formerly.  As  the  country  grows  older, 
as  population  increases,  as  competition  becomes  keener,  the 


io  PRINCIPLES  OF  ACCOUNTING 

need  of  efficiency  in  production  is  emphasized.  The  problem 
of  improving  the  utilization  of  our  economic  resources  is  one  of 
the  most  important  of  modern  questions.  The  solution  of  this 
problem  requires  a  very  extensive  statistical  analysis  of  the 
productive  process. 

THE  GENERAL  PROBLEMS  OF  ACCOUNTING 

From  the  standpoint  of  the  equities  involved  the  accounting 
records  of  a  business  enterprise  should  furnish  two  kinds  of  state- 
ments :  (i)  a  history  of  the  operation  of  the  enterprise  during 
the  fiscal  or  accounting  period ;  (2)  a  statement  of  the  financial 
status  of  the  business  at  the  end  of  the  period.1  These  statements, 
the  income  sheet  and  the  balance  sheet,  present  the  results  of  the 
entire  accounting  process.  The  income  sheet  shows  a  summary 
of  all  the  outlays  necessary  to  the  operation  of  the  business  and 
all  revenues  accrued.  The  balance  sheet  presents  a  statement 
of  all  the  property  items  at  a  given  moment,  and  shows  the 
distribution  of  the  ownership  in  the  same. 

The  income  sheet  may  be  used  for  managerial  purposes,  and 
it  is  of  general  importance  in  deciding  questions  of  equity.  If 
the  entire  property  is  owned  outright  by  one  person,  inaccuracies 
in  this  information  or  an  entire  absence  of  such  data  cause  no 
injustice  between  individuals.  If  the  number  of  investors  is 
large  and  if  their  equities  vary  considerably  in  character,  however, 
the  problem  of  ascertaining  these  facts  is  at  once  more  difficult 
and  more  important.  In  the  corporation,  for  example,  the 
personnel  of  the  investors  is  continually  changing,  due  to  the 
ease  with  which  securities  can  be  transferred  from  one  individual 
to  another.  Thus  if  an  error  in  stating  net  revenue  is  made  in 
one  period  it  is  probable  that  the  rights  of  some  of  the  individuals 
whose  equities  have  been  misstated  cannot  be  restored  by  the 
correction  of  the  error  in  a  later  period.  Further,  there  is  the 
added  difficulty  of  apportioning  the  annual  net  revenue  among 
the  various  classes  of  security-holders.  This  may  be  illustrated 
by  the  case  of  a  certain  company  which  has  outstanding,  among 
other  equities,  six  per  cent  non-cumulative  preferred  stock. 
Through  an  error  in  accounting  analysis  in  the  annual  income 

1  Cf.  Hatfield,  Modern  Accounting,  p.  5. 


NATURE  AND  SCOPE  II 

sheet  for  one  year,  net  revenue  as  shown  was  not  sufficient  to 
pay  the  regular  six  per  cent  dividend.  The  loss  of  this  dividend 
by  the  preferred  stockholders  cannot  be  regained  in  later  periods. 
In  fact,  this  loss  will  inure  to  the  benefit  of  the  common  stock- 
holders. Assuming  that  it  is  possible  to  expand  the  business 
and  increase  net  earnings  through  the  retention  of  profits  in  the 
enterprise,  it  would  be  to  the  advantage  of  the  common  stock- 
holders, who  have  the  larger  element  of  control,  to  adopt  a  policy 
which  would  lead  to  an  understatement  of  net  revenue.  The 
accountant  is  called  upon  to  pass  judgment  upon  accounting 
procedure  which  affects  net  revenue,  and  hence  the  relations 
between  the  various  equities. 

Similarly  the  status  of  the  equities  represented  in  the  enter- 
prise must  be  determined  at  various  moments  of  time.  Not 
only  must  net  revenue  be  apportioned  between  the  different 
classes  of  investors,  but  the  status  of  each  equity  must  be  shown 
after  this  division  is  made.  The  determination  of  net  revenue 
and  hence  the  condition  of  the  equities  involves  the  problem  of 
valuation;  i.e.,  the  ascertaining  of  property  expirations  and 
property  balances.  Only  from  such  information  in  regard  to 
the  condition  of  property  can  the  financial  condition  of  the 
equities  in  the  enterprise  be  ascertained.  These  data  must  be 
furnished  to  the  present  investor  if  he  is  to  know  the  status  of 
his  investment.  The  prospective  creditor  or  investor  must  also 
have  this  information  if  he  is  to  proceed  rationally  in  the  use  of 
his  capital.  Further,  if  the  state  is  to  do  justice  to  all  parties 
concerned  in  the  adjudication  of  disputes,  such  statistics  must 
be  available. 

Ordinarily  only  the  individuals  who  furnish  capital  to  an 
enterprise  are  considered  as  having  equities  in  the  property. 
Under  certain  conditions,  however,  the  public  interest  approaches 
the  nature  of  an  equity.  The  state  always  reserves  the  right 
to  appropriate  a  portion  of  investment  or  revenue  by  taxation. 
Further,  in  so  far  as  the  state  assumes  control  of  prices  and 
methods  of  financing,  it  has  an  interest  which  carries  with  it 
more  control  than  the  equity  of  the  private  investor.  In  the 
case  of  the  municipal  enterprise  already  mentioned  the  public 
exercises  complete  ownership,  and  here  the  public  interest  con- 
stitutes a  distinct  equity.  The  continued  recognition  of  the 


12  PRINCIPLES   OF   ACCOUNTING 

rights  of  private  property  still  insisted  upon  by  the  courts,  how- 
ever, makes  it  imperative  that  action  tending  toward  public 
regulation  shall  not  injure  the  private  equities.  Consider  the 
regulation  of  railroad  rates,  for  example.  It  is  recognized  that 
railway  transportation  is  a  quasi-monopolistic  industry  and  that 
the  proper  rates  cannot  be  fixed  by  competition.  The  public 
has  determined  that  the  rates  shall  not  be  exorbitant.  The  courts, 
having  in  mind  the  rights  of  private  property,  insist  on  the  other 
hand  that  the  rates  fixed  by  the  state  shall  be  high  enough  to 
yield  a  "reasonable  return  on  the  fair  value  of  the  property." 
The  point  should  be  emphasized  that  the  viewpoint  of  the  pri- 
vate equities  is  still  dominant  in  accounting. 

Even  the  rights  of  the  laborer  represent  an  equity  in  the  busi- 
ness enterprise  when  the  term  equity  is  broadly  interpreted. 
The  wage-earner's  right  to  a  portion  of  the  earnings  of  an  enter- 
prise has  a  definite  legal  status.  Especially  in  certain  indus- 
tries is  the  laborer  coming  to  have  an  authoritative  voice  in  the 
control  of  operation.  Although  the  interests  of  the  laborer  and 
the  public  are  not  recognized  in  the  accounting  records  as  equi- 
ties per  se,  still  the  accountant  must  recognize  the  influence  of 
both  of  these  interests  upon  accounting  problems.  It  is  possible 
that  in  time  a  more  definite  recognition  will  be  given  these  equi- 
ties in  the  accounts. 

Although  the  statistics  of  management  are  closely  connected 
with  the  problems  of  the  equities,  and  are  in  a  sense  subsidiary 
to  them,  nevertheless  this  branch  of  accounting  requires  the  use 
of  other  information  than  that  furnished  by  the  purely  financial 
records.  A  further  analysis  of  both  physical  and  value  facts  is 
necessary  for  efficient  management.  The  manager  must  have 
the  information  necessary  to  base  rational  judgments  as  to  the 
effective  utilization  of  the  resources  at  his  disposal.  The  re- 
lation of  this  question  to  financial  success,  and  the  tendency 
to  emphasize  this  phase  of  accounting,  can  be  illustrated  from  the 
railroad  industry.  Twenty-five  years  ago  the  attention  of  the 
operating  officials  was  centered  upon  the  gross  revenue  figure, 
rather  than  upon  costs.  The  conquest  of  new  territory  through 
the  extension  of  main  lines,  and  the  development  of  branch  lines 
and  feeders,  characterized  the  railroad  industry  and  made  pos- 
sible the  constant  and  rapid  growth  in  gross  revenues.  Economy 


NATURE  AND  SCOPE  13 

of  organization  was  entirely  overlooked  in  the  scramble  for  traffic. 
To-day  gross  revenue  has  reached  a  more  stable  position.  No 
longer  is  it  possible  to  cover  up  gross  inefficiency  in  management 
with  revenue  from  constantly  increasing  traffic.  In  view  of  the 
rise  in  wages  and  other  expenses  the  only  possibility  of  preserving 
the  margin  of  profit  is  through  an  increase  in  efficiency.  This 
situation  is  reflected  in  the  building  of  new  roads.  In  late  years 
the  increase  in  mileage  has  been  comparatively  insignificant, 
although  a  considerable  extension  of  trackage  has  been  made; 
that  is,  lines  are  not  being  extended,  but  already  existing  lines 
are  being  double-tracked  and  otherwise  improved. 

This  situation  is  duplicated  in  all  lines  of  industry.  To  pre- 
vent costs  from  encroaching  upon  the  profit  margin,  managerial 
efficiency  is  necessary.  The  manager  is  called  upon  to  pass 
judgments  as  to  the  most  effective  utilization  of  the  economic 
factors  available.  What  are  the  most  effective  combinations 
of  factors?  What  are  the  most  efficient  processes?  What  are 
the  best  methods  of  organizing  and  paying  labor  to  secure 
efficiency  in  production?  These  and  similar  questions  the 
managers  must  answer.  It  is  the  function  of  cost  accounting, 
so-called,  to  furnish  the  statistical  information  necessary  to  aid 
the  manager  in  making  these  judgments. 


PART   ONE 
ELEMENTS  OF  ACCOUNTING 


n 

THE  THEORY  or  BALANCE  SHEET  ACCOUNTS 

THE  first  step  in  the  study  of  accounting  is  the  mastery  of  the 
main  principles  underlying  the  construction  of  modern  financial 
accounts.  The  details  of  bookkeeping  procedure  can  be  more 
readily  grasped,  and  the  significance  of  specific  questions  of  ac- 
counting analysis  can  be  more  fully  appreciated,  if  the  student 
is  able  to  refer  these  matters,  as  they  arise,  to  a  background  of 
general  principles.  It  is  the  purpose  of  the  present  chapter  and 
the  next  to  furnish  this  background  by  explaining  the  structure 
of  the  principal  types  of  accounts  in  terms  of  the  important  facts 
and  concepts  with  which  accounting  is  concerned. 

THE  FUNDAMENTAL   CLASSES   OF  DATA 

As  was  emphasized  in  the  preceding  chapter,  the  important 
unit  of  organization  with  which  accounting  deals  is  the  specific 
business  enterprise.  The  fundamental  concepts  of  accounting 
can  be  defined,  and  the  nature  of  the  system  of  accounts  neces- 
sary to  record  the  various  happenings  which  may  occur  can  be 
adequately  expressed,  only  in  terms  of  the  needs  and  purposes  of 
a  particular  business  concern.  It  will  be  convenient,  therefore, 
to  take  a  hypothetical  business,  the  A.  B.  Co.,  at  its  inception, 
and  to  classify  the  facts  which  its  accounts  must  show,  both  at 
the  outset  and  after  operation  has  begun.  The  structure  of  the 
accounts  will  be  explained  in  terms  of  this  classification. 

The  A.  B.  Co.,  it  may  be  supposed,  is  a  small  manufacturing 
enterprise,  completely  organized  and  ready  to  begin  operation. 
What  are  the  data  necessary  to  a  statement  of  the  firm's  financial 
status?  What  fundamental  classes  of  value  facts  can  be  dis- 
covered? Clearly  one  important  category  embraces  all  the 
c  17 


l8  PRINCIPLES  OF  ACCOUNTING 

property  or  asset  items  to  which  the  A.  B.  Co.  has  title.  If  any 
conclusions  are  to  be  drawn  as  to  the  financial  condition  of  this 
company,  a  complete  statement  of  property  must  be  available. 
This  property  might  consist  not  only  in  many  different  kinds  of 
tangible  goods,  but  also  in  valuable  rights,  securities,  etc.  Mate- 
riality is  no  satisfactory  test  as  to  what  is  or  what  is  not  an  asset, 
and  this  is  one  of  the  important  facts  which  must  be  kept  in  mind 
if  one  is  to  appreciate  the  significance  of  the  term.  An  asset 
can  be  defined  as  any  consideration,  material  or  otherwise,  owned 
by  a  specific  business  enterprise  and  of  value  to  that  enterprise. 
Thus  an  asset  is  essentially  an  economic  fact,  and  in  the  strict 
accounting  sense  must  be  connected  with  some  particular  busi- 
ness establishment. 

In  preparing  a  statement  of  the  financial  condition  of  an 
enterprise  the  various  kinds  of  assets  can  be  listed  or  classified 
very  minutely,  or  they  can  be  stated  under  a  few  heads.  How 
far  these  items  shall  be  subdivided  is  purely  a  matter  of  con- 
venience, depending  upon  the  character  of  the  enterprise  in 
question  and  the  particular  purpose  which  the  classification  is 
intended  to  serve.  A  small  mercantile  establishment  may  re- 
quire but  a  few  classes  of  property ;  a  railroad  corporation  may 
make  use  of  hundreds  of  distinct  assets.  The  property  of  the 
A.  B.  Co.,  it  will  be  assumed,  consists  in  the  following  assets: 
land,  $40,000 ;  building,  $70,000 ;  equipment,  $20,000 ;  mate- 
rials, $80,000;  cash,  $15,000.  Then  the  financial  statement  of 
the  firm  must  show  this  list  of  assets ;  and  the  items  may  be  ar- 
ranged in  any  intelligible  way.  A  convenient  method  of  presenta- 
tion is  the  listing  of  the  assets  in  a  column,  one  below  another, 
thus: 

ASSETS 

Land $40,000 

Building 70,000 

Equipment 20,000 

Materials       80,000 

Cash 15,000 

Total      .    .    .    . $225,000 

Does  this  list  of  facts  present  a  satisfactory  statement  of  the 
financial  condition  of  the  company  ?  Does  a  statement  of  assets 
cover  all  of  the  logical  classes  of  data  involved  in  the  enterprise  ? 


THEORY  OF  BALANCE  SHEET  ACCOUNTS      19 

No,  such  a  statement  is  clearly  inadequate,  either  from  the  stand- 
point of  the  interests  of  the  A.  B.  Co.,  a  probable  purchaser  of 
-  or  investor  in  —  the  business,  or  any  other  party  concerned. 
The  situs  of  the  title  to  this  property  must  be  determined.  What 
are  the  claims  against  or  rights  in  this  property?  Where  is  the 
distribution  of  ownership?  Or  more  concisely:  what  are  the 
equities  in  these  assets? 

The  equities  like  the  asset  items  may  have  a  variety  of  forms. 
The  particular  interest  which  has  immediate  control  of  opera- 
tion may  own  all  the  assets  clear,  or  it  may  have  only  a  small 
net  interest  in  the  property  and  the  greater  part  of  the  ownership 
may  be  vested  in  outside  parties  whose  claims  may  consist  in 
contractual  liens  and  rights  represented  by  bonds,  mortgages, 
promissory  notes,  accounts  payable,  etc.  In  this  case  it  will  be 
assumed  that  the  rights  in  the  assets,  or  equities,  consist  in  the 
following  items:  the  proprietors'  equity,  $170,000;  mortgages, 
$35,000;  notes  payable,  $20,000. 

The  first  of  these  items  —  often  called  proprietorship  —  rep- 
resents the  owners  in  the  narrow  sense ;  it  is  the  equity  of  those 
who  have  the  large  element  of  direct  control  of  business  opera- 
tion and  financial  policies.  In  a  single-proprietor  enterprise 
the  "capital"  and  "personal"  accounts  of  the  individual  pro- 
prietor furnish  a  record  of  this  equity ;  and  in  a  partnership  the 
capital  and  personal  accounts  of  the  individual  partners  are  used 
to  represent  proprietorship.  In  the  case  of  an  incorporated 
enterprise  proprietorship  is  represented  by  the  capital  stock 
outstanding  less  the  discount  or  deficit  if  any  item  of  this  nature 
is  present,  or  capital  stock  plus  surplus  if  any  such  item  exists. 
For  the  time  being  it  will  be  advisable  to  postpone  further  dis- 
cussion of  the  general  nature  of  this  equity  or  its  peculiarities 
under  different  forms  of  organization;  and  in  the  case  of  the 
A.  B.  Co.  this  item  can  be  designated  simply  by  the  name  of  the 
firm.  Because  of  the  fact  that  the  proprietors'  equity  represents 
the  parties  in  immediate  control,  and  because  this  equity  is  often 
—  although  not  always  —  much  the  largest  in  amount,  proprie- 
torship is  the  most  important  equity  from  the  standpoint  of  ac- 
counting; and  in  later  chapters  it  will  be  necessary  to  discuss 
in  some  detail  its  accounting  significance. 

These  equity  facts  may  be  listed  in  a  column,  as  was  done  in 


20  PRINCIPLES  OF  ACCOUNTING 

the  case  of  the  asset  items.  The  two  columns  may  now  be 
grouped  in  any  convenient  way.  The  following  arrangement 
is  a  conventional  form : 

ASSETS  EQUITIES 

Land $40,000  A.  B.  Co $170,000 

Building 70,000  Mortgages 35.ooo 

Equipment 20,000  Notes  Payable   ....        20,000 

Materials 80,000 

Cash 15,000 

Total $225,000  Total $225,000 

This  balance  sheet  form  of  presenting  a  statement  of  a  firm's 
financial  condition  at  a  given  moment  is  a  lucid  and  concise  way 
of  showing  the  necessary  facts,  although  it  is  not  the  only  possible 
method.  The  essential  thing  is  to  have  all  of  the  facts  presented 
and  arranged  in  the  most  intelligible  form ;  and  from  every  point 
of  view  it  appears  desirable  to  separate  in  some  way  the  two 
distinct  categories,  assets  and  equities.  One  writer  has  observed 
that  the  balance  sheet  is  the  "groundwork  of  accountancy." 1 
Certainly  the  balance  sheet  as  conceived  in  the  above  table  rep- 
resents a  classification  of  facts  which  is  the  basis  of  the  funda- 
mental accounting  concepts  and  the  technical  structure  of  the 
accounts. 

THE   ACCOUNTING  EQUATION 

It  is  apparent  that  these  two  classes  of  facts  will  in  every  case 
be  numerically  equal,  for  they  are,  in  a  sense,  merely  different 
aspects  of  the  same  thing.  The  asset  class  constitutes  a  list  of 
objective  property  items;  the  equity  class  represents  the  legal 
relationships  between  this  same  property  and  certain  individuals 
or  interests.  That  is,  one  class  represents  the  valuable  com- 
modities and  rights  of  a  given  enterprise,  the  other  class  repre- 
sents the  distribution  of  ownership,  or  the  claims  against  assets, 
or,  more  exactly,  the  equities  in  assets.2  And  since  the  same 

1  Sprague,  The  Philosophy  of  Accounts,  p.  26. 

*  To  observe  strictly  the  legal  fiction  in  the  case  of  an  incorporated  enterprise 
one  should  say,  not  "equities  in  assets,"  but  equities  in  the  enterprise.  A  stock- 
holder, for  example,  has  no  claim  or  title  to  any  specific  asset.  From  the  stand- 
point of  accounting,  however,  it  is  no  serious  error  to  say  that  an  equity,  in  every 
case,  is  virtually  a  right  in  assets. 


THEORY  OF  BALANCE  SHEET  ACCOUNTS  21 

measuring  unit,  the  dollar,  is  used  in  stating  both  classes  of  facts, 
the  totals  are  always  numerically  equal. 

One  or  two  simple  illustrations  may  serve  to  make  clear  the 
nature  and  necessity  of  this  fundamental  equation.  A  certain 
individual  has  $100  in  cash  in  his  pocket.  This  represents  his 
entire  capital,  and  he  has  no  obligations.  What  are  the  facts 
necessary  for  a  complete  representation  of  his  financial  status? 
There  are  two  essential  facts  present.  The  cash  in  his  possession 
has  two  aspects :  one  is  its  significance  as  an  objective  bit  of 
property;  the  other  is  the  fact  of  the  ownership  of  this  asset. 
Looking  upon  the  individual  as  an  enterprise,  then,  his  balance 
sheet  would  appear  as  follows : 

ASSETS  EQUITIES 

Cash $100    An  Individual,  Capital      .    .    $100 

Both  classes  of  facts  —  property  and  the  ownership  of  that  prop- 
erty —  are  present,  whether  expressed  or  not.  In  a  simple  situa- 
tion such  as  this,  it  might  well  be  that  the  owner  of  the  cash  would 
take  his  ownership  for  granted,  and  if  asked  to  prepare  a  state- 
ment of  his  financial  condition  he  would  probably  present,  simply : 

AN  INDIVIDUAL,  FINANCIAL  STATEMENT 
Cash $100 

This  does  not  mean  that  both  classes  of  facts  are  not  present  — 
inevitably ;  but  in  this  case  the  actual  classification  is  not  made. 
On  a  student's  desk  ten  books  are  scattered,  worth,  it  may  be 
assumed,  one  dollar  apiece.  The  student  owns  seven  of  these 
books,  and  three  are  borrowed  from  his  next-door  neighbor.  A 
balance  sheet  representing  these  books  and  their  ownership  as 
an  enterprise  would  then  appear  as  follows : 

ASSETS  EQUITIES 

Books $10     Student,  Ownership   ....     $  7 

Neighbor,  Ownership      .     .     .     3 

Total $10  Total $10 

It  would  seem  fairly  obvious,  then,  that  assets  and  equities  are 
always  equal,  no  matter  how  simple  or  complex  may  be  the  situa- 


22  PRINCIPLES  OF  ACCOUNTING 

tion  or  enterprise  under  consideration.  Assets  and  equities  are 
distinct  but  interdependent  classes  of  facts.  One  class  cannot 
cxi-t  without  the  other,  and  the  totals  in  each  case  are  equal. 
This  classification,  and  its  equality,  is  at  the  foundation  of  every 
system  of  modern  accounts.  Business  transactions  consist 
essentially  in  the  alteration  of  one  or  both  members  of  this  equa- 
tion ;  but  the  equality  of  totals  —  as  will  be  shown  a  little  later 
-  is  continuously  maintained. 

Certain  apparent  exceptions  in  accounting  practice  to  this 
fundamental  equation  should  be  briefly  noted  at  this  point.  A 
feature  of  the  structure  of  modern  accounts  which  will  be  ex- 
plained in  detail  in  the  next  section  of  this  chapter  is  the  sub- 
stitution of  addition  for  subtraction  wherever  possible.  This 
procedure  secures  neatness,  and  economy  of  clerical  effort ;  and 
there  are  in  many  cases  special  reasons  for  maintaining  original 
figures.  It  is  convenient,  for  example,  to  list  securities  in  the 
accounts  at  par.  If,  then,  a  company  secures  its  capital  through 
the  issue  of  securities  at  a  discount  this  will  mean  that  the  nominal 
(par)  value  of  the  securities  outstanding  is  greater  than  the 
amount  of  cash  and  other  assets  actually  invested.  Then  if  this 
par  value  is  recorded  as  an  equity,  instead  of  the  actual  amount 
of  the  equity,  the  extent  to  which  this  item  is  overstated  may  be 
indicated  by  including  the  amount  of  the  discount  among  the 
asset  items. 

A  corporation,  for  example,  issues  capital  stock  to  the  amount 
of  $50,000  (par  value)  although  the  actual  investment  made  by 
the  stockholders  is  but  $45,000.  In  other  words,  the  stock  is 
issued  at  a  discount  of  ten  per  cent.  The  balance  sheet  represent- 
ing this  condition  would  appear,  in  summary  form,  as  follows  : 

ASSETS  EQUITIES 

Cash  and  Other  Assets  .  $45,000  Capital  Stock  ....  $50,000 
Discount  on  Stock  .  .  .  5,000 

Total $50,000  Total $50,000 

The  item  of  discount  is  not  an  asset  but  a  deduction  from  an 
equity,  capital  stock,  which  is  maintained  in  the  records  at  nomi- 
nal figures.  Actual  assets  amount  to  but  $45,000,  and  therefore 
the  amount  of  actual  ownership  is  also  but  $45,000.  The  funda- 


THEORY  OF  BALANCE  SHEET  ACCOUNTS 


23 


mental  equation  exists  in  this  case  as  in  all  others,  although  there 
is  an  apparent  discrepancy  equal  to  the  amount  of  the  discount. 

Similarly,  whenever  the  assets  of  an  enterprise  are  being  dis- 
sipated through  losses,  and  the  equities  are  maintained  at  the 
old  amounts,  there  is  an  apparent  discrepancy.  But  the  use  of 
original  figures  for  the  equities  when  assets  have  disappeared  is 
purely  conventional.  In  the  case  of  insolvency  equities  nomi- 
nally exceed  assets,  but  virtually  the  equation  is  maintained  — 
the  insolvent  firm  pays  less  than  one  hundred  cents  "on  the 
dollar." 

Further,  asset  items  are  sometimes  left  at  original  figures  for 
various  reasons  and  deductions  are  listed  among  the  equities. 
It  will  be  sufficient  at  this  point  to  say  that  the  substitution  of 
addition  on  the  opposite  side»of  the  equation  instead  of  actual 
subtraction,  or,  as  it  is  sometimes  put,  the  use  of  valuation  items 
(see  Chapter  III)  explains  all  apparent  exceptions  to  the 
equation,  assets  equal  equities. 

It  is  customary  to  denominate  the  right-hand  member  of  the 
equation  liabilities.  It  might  be  urged  that  this  is  improper 
terminology,  since  this  term  has  the  connotation  of  debts  or 
outside  obligations  and  this  meaning  clearly  does  not  apply  to 
the  proprietor's  equity.  If  the  term  equities  —  which  covers 
all  elements  of  ownership  —  were  used  instead,  there  would  be 
less  danger  of  misunderstanding.  For  it  must  be  recognized 
that  there  are  important  distinctions  between  proprietorship  and 
the  liabilities  proper.  The  liabilities  are  contractual  in  character ; 
proprietorship  is  residual.  The  liabilities  carry  less  control  and 
risk  and  have  contractual  rights  to  income;  the  proprietor's 
equity  carries  the  large  element  of  control  and  risk  and  has  resid- 
ual rights  to  income.  These  distinctions  can  be  more  sharply 
drawn  in  the  case  of  the  small  single-proprietor  enterprise  or 
partnership  than  in  the  large  incorporated  enterprise.  In  the 
typical  modern  corporation  the  important  aspects  of  ownership 
-  control,  risk  and  income  —  have  been  so  subdivided  and  com- 
bined through  the  specialization  of  securities  that  it  is  difficult, 
in  many  cases,  to  define  proprietorship  clearly.  Nevertheless 
the  general  distinction  exists,  and  to  include  proprietorship  and 
contractual  obligations  under  the  caption,  liabilities,  is  very 
confusing.  To  avoid  this  confusion  the  term  equities  will  be 


24  PRINCIPLES  OF  ACCOUNTING 

used  throughout  the  text  to  designate  the  right-hand  member 
of  the  balance  sheet  equation. 

The  financial  statistics  of  any  business  enterprise  can  thus  be 
listed  in  two  fundamentally  distinct  and  numerically  equal 
classes,  assets  and  equities;  and,  as  was  stated  above,  the  es- 
sence of  any  complete  system  of  accounts  consists  in  the  separa- 
tion of  the  members  of  this  equation  and  the  maintenance  of 
this  classification.  With  this  equation  as  a  basis  a  convenient 
and  intelligible  system  of  ordering  and  presenting  the  necessary 
facts  is  built  up ;  and  —  as  will  appear  later  —  an  important 
characteristic  of  this  system  is  the  test  for  arithmetical  accuracy 
afforded  by  this  continuous  equation.  The  explanation  as  to 
how  the  accounts  are  constructed  from  this  basic  classification 
will  now  be  undertaken. 


THE   CONSTRUCTION   OF   ACCOUNTS 

The  hypothetical  A.  B.  Co.  begins  operations.  It  will  be 
necessary  at  this  point  to  consider  briefly  just  what  the  opera- 
tion of  a  business  enterprise  means  in  terms  of  the  effect  upon  the 
asset  and  equity  classes.  An  equipment  of  commodities  such  as 
land,  buildings,  tools,  raw  materials,  etc.,  together  with  services 
such  as  ordinary  labor,  management,  advertising,  insurance,  etc., 
is  incorporated  with  the  services  of  the  owners  l  themselves  and 
results  in  a  flow  of  product  —  either  commodities  or  services  — 
which  is  sold  to  the  consuming  public.  The  continued  produc- 
tion of  this  commodity  or  service  can  be  secured  only  at  the 
expense  of  constant  decay,  replacement  and  change  among  the 
asset  elements  involved.  In  other  words  there  will  always  be  a 
continual  shifting  among  the  asset  items  as  business  operation 
proceeds.  Similarly  as  respects  the  facts  of  ownership  a  process 
of  transposition  and  general  change  will  normally  be  taking 
place :  the  amounts  and  character  of  the  equities  will  be  altered 
from  time  to  time. 

It  is  evident  that  the  accounts  of  an  enterprise  should  be  so 
constructed  that  record  may  conveniently  be  made  of  these 

1  The  individuals  and  interests  represented  by  the  equities  furnish  the  capital 
invested  in  the  enterprise  and  have  ultimate  control  of  operation.  The  proprietors, 
particularly  in  small  enterprises,  often  furnish  labor  services  as  well  as  capital. 


THEORY  OF  BALANCE  SHEET  ACCOUNTS      25 

changes  which  occur  on  both  sides  of  the  fundamental  equation. 
It  would  be  possible  to  follow  these  changes  simply  by  altering 
in  the  proper  amount  and  direction  the  asset  and  equity  items  as 
they  appear  on  a  tabular  financial  statement  such  as  was  given 
above,  and  when  new  types  of  assets  are  secured,  or  when  new 
equities  appear,  these  new  headings  could  be  listed  in  the  same 
way.  An  obvious  objection  to  this  procedure  is  its  inconvenience 
for  any  but  the  simplest  cases.  The  fundamental  objection  is 
that  accounting  statements  so  constructed  would  throw  little 
light  upon  the  business  process,  and,  as  was  emphasized  in  the 
preceding  chapter,  the  data  of  the  historical  as  well  as  the  synoptic 
situation  are  necessary  to  meet  the  needs  of  the  different  in- 
terests involved. 

It  will  be  necessary,  then,  to  extend  or  stretch  out  the  above 
financial  statement  of  the  A.  B.  Co.  so  that  space  will  be  avail- 
able for  the  recording  of  the  transactions  which  may  affect  the 
original  amounts.  This  virtually  means  the  opening  of  an  ac- 
count for  each  kind  of  asset  and  for  .each  equity,  thus : 

Land  A.   B.    Co. 

$40,000  $170,000 

Building  Mortgages 

$70,000  $35,00° 

Equipment  Notes  Payable 

$20,000  $20,000 

Materials 


$80,000 

Cash 


$15,000 


Now  what,  in  the  first  place,  will  be  the  effect  upon  asset 
amounts  of  the  various  transactions  which  may  occur  ?  Clearly 
asset  items  may  be  altered  in  two  directions :  an  asset  balance 
may  be  either  increased  or  decreased  —  there  may  be  additions 
to  assets  or  there  may  be  subtractions  or  withdrawals  from  assets. 


26  PRINCIPLES  OF  ACCOUNTING 

It  is  evident  that  all  possible  change  can  be  summed  up  in  this 
numerical  manner  when  one  realizes  that  it  is  not  the  building 
or  machine  which  is  recorded  in  the  accounts  but  rather  its  value 
representation.  That  is,  immediately  speaking  an  asset  is  an 
amount,  and  although  changes  in  this  amount  may  be  due  to 
various  causes  they  can  occur  in  but  two  directions  —  the  posi- 
tive and  negative. 

Accordingly  it  will  be  desirable  to  have  two  separate  columns 
under  each  asset  heading,  one  for  additions  or  positive  items  and 
one  for  subtractions  or  negative  items.  Now  how  shall  these 
columns  be  arranged  ?  Shall  the  positive  items  be  preserved  at 
the  left  and  the  subtractions  at  the  right  or  vice  versa?  The 
answer  to  this  question  is  not  at  all  a  matter  of  principle ;  either 
arrangement  will  serve,  as  well  as  the  other.  In  the  tabular 
statement  of  assets  and  equities  given  above  the  asset  items  were 
set  at  the  left  and  the  equity  balances  at  the  right.  This  is  the 
conventional  arrangement  followed  in  this  country  although 
the  English  practice  is  just  the  reverse.  The  essential  thing  is 
a  separation  of  the  two  fundamental  classes  of  facts;  the  ar- 
rangement of  data  after  the  classification  is  made  is  a  matter  of 
comparatively  little  importance.  But  if  it  is  decided  to  have 
left  stand  for  asset  balances  and  right  for  equity  balances  in  the 
accounts,  then  it  will  be  necessary  in  the  positive  and  negative 
columns  under  each  asset  heading  to  use  the  left-hand  column 
for  additions  and  the  right-hand  column  for  subtractions,  in 
order  to  preserve  positive  balances  at  the  left.  This  gives  the 
essential  nature  of  any  modern  account :  two  columns,  one  for 
additions  and  one  for  subtractions ;  and  custom  decrees  that  in 
asset  accounts  the  left-hand  column  shall  be  used  for  additions, 
the  right-hand  for  subtractions. 

Similarly,  transactions  affecting  the  equity  items  may  result 
in  either  increasing  or  decreasing  an  equity  balance.  Conse- 
quently each  equity  account  has  need  of  two  columns,  a  positive 
column  for  additions  and  a  negative  column  for  subtractions. 
What  shall  be  the  arrangement  of  these  columns?  Again  the 
answer  is  that  the  arrangement  is  an  arbitrary  matter,  the  only 
essential  consideration  in  constructing  the  accounts  being  the 
preservation  of  the  fundamental  classification,  assets  and  equi- 
ties. But,  since  it  was  decided  to  keep  positive  asset  balances 


THEORY  OF  BALANCE   SHEET  ACCOUNTS  27 

at  the  left  and  equity  balances  at  the  right,  it  will  be  necessary 
in  the  positive  and  negative  columns  under  each  equity  heading 
to  use  the  right-hand  column  for  additions  and  the  left-hand 
column  for  subtractions. 

It  is  important  to  note  that  the  definition  of  the  account  in 
terms  of  parallel  columns,  as  given  above,  is  somewhat  arbitrary. 
A  balance  sheet  account,  in  a  broad  sense,  consists  in  a  record 
of  plus  and  minus  happenings  in  connection  with  some  specific 
asset  or  equity  item.  The  parallel-column  arrangement  is  only 
one  of  many  possible  devices  for  presenting  such  a  record.  Vari- 
ous symbolic  schemes  as  well  as  other  methods  of  spatial  arrange- 
ment could  be  readily  suggested.  Plus  and  minus  signs,  for 
example,  might  be  used  to  designate  additions  and  subtractions 
respectively,  or  inks  of  different  colors.  An  actual  physical 
separation  of  plus  and  minus  items  is  very  desirable,  however, 
from  the  standpoint  of  clerical  efficiency ;  and  because  it  makes 
such  a  separation  the  parallel-column  arrangement  is  a  highly 
practicable  device.  Hereafter  in  speaking  of  an  account  the 
conventional  form  will  be  understood. 

The  scheme  of  the  construction  of  the  balance  sheet  accounts 
in  their  relation  to  the  fundamental  classes  can  be  represented 
thus : l 

1  These  accounts  —  since  each  is  a  distinct  unit  —  might  be  arranged  in  any  order 
whatever  without  disturbing  the  equality  of  left-hand  and  right-hand  balances. 
Thus,  in  practice,  the  accounts  of  an  enterprise  are  often  kept  in  a  bound  volume, 
arranged,  not  in  asset  and  equity  groups,  but  alphabetically. 


28 


PRINCIPLES  OF  ACCOUNTING 
THE  A.  B.  Co. 


ASSETS 


EQUITIES 


ADDITIONS                   SUBTRACTIONS 

SUBTRACTIONS                     ADDITIONS 

Land 

A.   B.   Co. 

$40,000 

$170,000 

Bui 

iding 

Mort 

gages 

$70,000 

$35,ooo 

Equi 

pment 

Notes  1 

5ayable 

$20,000 

$20,000 

Mat 

erials 

$80,000 

C; 

ish 

$15,000 

THEORY  OF  BALANCE  SHEET  ACCOUNTS  29 

Thus  far,  then,  it  appears  that  all  asset  balances  are  arbitrarily 
listed  on  the  left-hand  side  of  the  asset  accounts,  and  all  equity 
balances  on  the  right-hand  side  of  the  equity  accounts ;  and  the 
fact  should  be  emphasized  again  that  the  most  important  con- 
sideration controlling  the  construction  of  these  accounts  is  the 
maintenance  of  the  classification  represented  by  the  equation, 
assets  equal  equities. 

CLASSES   OF   TRANSACTIONS 

To  illustrate  the  way  in  which  business  transactions  are  re- 
corded in  the  accounts  a  few  typical  occurrences  will  be  analyzed 
and  their  effect  upon  the  fundamental  equation  noted. 

a.  Raw  material  is  purchased  by  the  A.  B.  Co.  for  cash,  $600. 
This  illustrates  a  very  common  type  of  transaction.     One  asset 
(usually  cash)  is  paid  out  and  another  kind  of  asset  of  equal  value 
is  received  in  exchange ;  this  means  a  subtraction  from  one  asset 
and  an  equal  addition  to  another.     Proceeding  in  the  manner 
outlined  in  the  preceding  section  an  entry  of  $600  must  be  made 
in  the  right-hand  column  of  the  Cash  account  and  an  equal  entry 
in  the  left-hand  column  of  the  Materials  account.     This  gives 
two  equal  entries  in  opposite  columns,  and  the  original  equality 
between  asset  balances   and   equity  balances  is  undisturbed. 
The  purchase  of  any  commodity  or  service  for  cash  or  an  equiva- 
lent gives  a  transaction  which  comes  under  this  head.     Such 
occurrences  obviously  affect  only  one  member  of  the  balance 
sheet  equation,  the  assets ;  and  the  total  of  the  assets  is  unchanged. 
Such  transactions  involve  simply  plus  and  minus  occurrences 
among    the   various    assets  —  transpositions   of   assets.     They 
are  all  recorded  in  this  way. 

b.  The  A.  B.  Co.  is  planning  some  heavy  purchases  of  mate- 
rials and  other  supplies  and  borrows  $5,000  from  a  bank  on  a 
ninety-day  note.     Here  an  asset  is  increased  and  at  the  same 
tune  an  equity,  notes  payable,  is  increased  a  like  amount  —  an 
addition  to  cash  and  an  equal  addition  to  notes  payable.     This 
transaction  would  be  recorded  by  a  left-hand  entry  of  $5,000  in 
the  Cash  account  and  an  equal  right-hand  entry  in  the  Notes 
Payable  account.     Again  the  result  is  two  equal  entries  in  op- 
posite columns,  and  the  equation,  assets  equal  equities,  is  main- 


30  PRINCIPLES  OF  ACCOUNTING 

tained.  This  transaction  affects  both  members  of  the  equation 
but  clearly  does  not  disturb  the  separation  of  the  two  kinds  of 
facts  or  their  equality.  A  note  of  the  A.  B.  Co.  falls  due  and  is 
retired  with  cash,  $1,000.  This  illustrates  the  reverse  of  the  pre- 
ceding transaction.  In  this  case  there  is  a  decrease  in  assets, 
cash,  and  an  equal  reduction  in  an  equity,  notes  payable.  Hence 
it  would  be  recorded  by  a  right-hand  entry  in  the  Cash  account 
of  $1,000  and  an  equal  left-hand  entry  in  the  Notes  Payable  ac- 
count. All  transactions  of  the  type  which  involve  an  addition 
to  assets  and  an  equal  addition  to  equities,  or  a  subtraction  from 
assets  and  an  equal  subtraction  from  equities,  are  recorded  in 
this  way. 

c.  A  transaction  may  involve  a  transposition  of  equities  — 
an  exchange  of  one  kind  of  equity  for  another.     The  A.  B.  Co., 
for  example,  issues  a  first  mortgage  on  land  and  building  for 
$5,000  in  exchange  for  $5,000  of  outstanding  notes  payable.    This 
transaction  involves  a  subtraction  from  one  equity,  notes  payable, 
and  an  equal  addition  to  another  equity,  mortgages.     It  would 
be  recorded  by  a  right-hand  entry  of  $5,000  in  the  Mortgages 
account  and  an  equal  left-hand  entry  in  the  Notes  Payable  ac- 
count.    All  such  transactions  clearly  affect  the  equities  only, 
and  not  the  total  of  this  class.     And  again  the  result  is  equal 
entries  in  opposite  columns,  leaving  the  equality  of  classes  un- 
disturbed. 

d.  A  transaction  may  involve  some  combination  of  the  above 
fundamental  types.     The  A.  B.  Co.,  for  example,  buys  addi- 
tional equipment  amounting  to  $4,000,  paying  cash,  $2,000,  and 
giving  a  ninety-day  note  for  the  balance.     This  transaction  in- 
volves an  increase  in  one  asset,  equipment,  a  decrease  in  another 
asset,  cash,  and  an  increase  in  an  equity,  notes  payable.     It 
would  be  recorded  by  a  left-hand  entry  of  $4,000  in  the  Equip- 
ment account,  a  right-hand  entry  of  $2,000  in  the  Cash  account, 
and  a  right-hand  entry  of  $2,000  in  the  Notes  Payable  account. 
All  such  transactions  are  simply  combinations  of  the  other  types 
illustrated  above,  and  give  equal  entries  in  opposite  columns  in 
every  case. 

Although  there  may  be  a  great  variety  of  combinations  and 
examples  of  the  above  cases,  these  illustrations  cover  the  funda- 
mental types  of  transactions  possible  in  any  business  enterprise. 


THEORY  OF  BALANCE   SHEET  ACCOUNTS  31 

An  increase  or  decrease  in  an  asset  must  be  accompanied  by  an 
equal  decrease  or  increase  in  another  asset  or  an  increase  or  de- 
crease in  an  equity.  And,  reversing  the  order  of  statement,  any 
change  in  an  equity  can  only  be  explained  by  an  equal  and  op- 
posite change  in  another  equity,  or  an  equal  change  in  an  asset 
in  the  same  direction.  Further,  any  combination  of  these  changes 
is  possible.  It  appears,  then,  that  every  transaction  is  two- 
sided,  that  is,  there  is  always  an  equal  right-hand  entry  (or 
entries)  for  every  left-hand  entry  (or  entries)  and  vice  versa; 
hence  the  original  equality  between  the  sum  of  the  left-hand 
(asset)  balances  and  the  sum  of  the  right-hand  (equity)  balances 
is  continuously  maintained. 


DOUBLE-ENTRY  —  DEBIT   AND   CREDIT 

The  asset  and  equity  classification  arranged  in  parallel-column 
accounts  is  the  basis  of  the  device  known  as  double-entry  book- 
keeping. The  term  double-entry  originates  in  connection  with 
the  equality  of  opposite  entries  just  explained.  Conceived  in 
this  way  the  double-entry  system  is  not  an  arbitrary  construc- 
tion depending  upon  a  particular  arrangement  of  data.  It  is 
rather  a  highly  rational  and  logical  system  founded  in  terms  of 
the  fundamental  classes  of  accounting  data  and  constructed  so 
as  to  record  conveniently  all  changes  in  these  classes.  The 
system  is  thus  more  rational  than  is  often  appreciated.  Any 
system  is  double-entry  which  represents  all  of  the  facts  in  the 
asset-equity  classification.  Any  system  of  accounts  which  does 
not  give  all  of  this  information  is  inadequate.  Single-entry  is 
the  term  applied  to  a  number  of  methods  of  keeping  accounts 
which  do  not  represent  all  of  the  facts.  In  the  case  of  very  simple 
situations  it  may  be  possible  to  deduce  all  unstated  facts  from  an 
incomplete  set  of  accounts ;  but  anything  short  of  the  complete 
double-entry  system  is  usually  more  complex  in  the  end.  In 
this  text  the  discussion  of  bookkeeping  methods  will  be  confined 
to  the  double-entry  system. 

In  practice  the  left-hand  side  of  all  accounts  is  called  the  debit 
side  and  the  right-hand  column  is  called  the  credit  side.  In  many 
explanations  of  double-entry  bookkeeping  an  attempt  is  made  to 
attach  the  significance  of  the  words  debtor  and  creditor  to  the 


32  PRINCIPLES  OF  ACCOUNTING 

terms  debit  and  credit  as  used  in  modern  accounts.  As  used  in 
personal  accounts  these  meanings  can  with  some  reason  be  ap- 
plied, for  example : 

A,  CUSTOMER 

(In  account  with  the  A.  B.  Co.) 
Dr.  Cr. 


$500 


$100 


Here  the  debit  and  credit  headings  of  the  opposite  columns  may 
be  thought  of  as  having  real  meanings.  A,  Customer  is  debtor 
to  the  A.  B.  Co.  for  the  sums  listed  in  the  debit  column  and 
creditor  to  the  A.  B.  Co.  for  the  sums  listed  on  the  credit  side. 
But  the  terms  debit  and  credit  are  applied  to  the  left-  and  right- 
hand  columns,  respectively,  of  all  accounts  in  the  double-entry 
system,  and  it  is  impossible,  rationally,  to  attach  such  meanings 
to  debit  and  credit  elsewhere  than  in  personal  accounts.  Ety- 
mologically  these  terms  are  doubtless  related  to  the  words 
debtor  and  creditor,  but  as  now  used  they  are  merely  conven- 
tional signs  employed  to  designate  left-hand  and  right-hand 
columns  in  the  accounts.  These  expressions  will  be  used  only 
with  this  significance  throughout  the  text. 

A  brief  summary  of  the  chapter  will  serve  to  emphasize  some 
of  the  important  points  discussed.  The  system  of  accounts  for 
a  business  enterprise  is  founded  logically  in  the  nature  of  the 
facts  with  which  accounting  deals.  These  data  consist  funda- 
mentally in  the  two  classes,  assets  and  equities  (rights  in  assets). 
The  asset  class  includes  all  valuable  items  regardless  of  their 
material  or  immaterial  character.  Any  commodity  or  service 
owned  by  a  business  enterprise  and  of  value  to  that  enterprise 
is  an  asset.  The  equities  represent  the  distribution  of  ownership. 
These  items  can  be  roughly  grouped  as  proprietorship  and  lia- 
bilities. This  grouping  is  based  upon  the  differentiation  of  owner- 


THEORY  OF  BALANCE  SHEET  ACCOUNTS  33 

ship  into  its  principal  elements.  Assets  always  equal  equities 
numerically  for  one  class  consists  in  the  objective  asset  items, 
the  other  class  represents  the  situs  of  the  ownership  of  these  same 
assets,  and  the  same  measuring  unit,  the  dollar,  is  used  in  both 
cases. 

Business  operation  means  a  constant  process  of  shifting  in 
both  asset  and  equity  items.  Assets  expire,  are  replaced,  are 
exchanged.  Any  asset  item  may  be  increased  or  reduced. 
Similarly  the  process  of  change  will  mean  increases  and  decreases 
in  specific  equity  items.  Accounts  with  the  various  items  of 
assets  and  equities  are  built  up  to  record  these  changes.  The 
important  characteristic  of  the  conventional  account  is :  two 
columns,  one  for  additions,  the  other  for  subtractions.  Arbitrarily 
it  is  decided  to  maintain  asset  balances  in  the  left-hand  column 
and  equity  balances  in  the  right-hand  column.  Therefore,  in 
asset  accounts,  the  left-hand  column  is  used  for  additions  and 
the  right-hand  column  for  subtractions ;  and  in  equity  accounts 
just  the  reverse  is  true.  The  only  important  consideration  con- 
trolling this  arrangement  is  the  maintenance  of  the  original 
equation. 

All  possible  transactions  can  be  classified  under  four  heads : 
(i)  an  asset  is  exchanged  for  another  asset  of  equal  value ;  (2)  an 
increase  or  decrease  in  assets  takes  place  through  an  equal  in- 
crease or  decrease  in  equities ;  (3)  an  equity  is  exchanged  for  an 
equal  amount  in  another  equity ;  (4)  a  transaction  may  involve 
some  combination  of  the  above  cases.  In  any  of  these  cases 
equal  entries  in  opposite  columns  are  made  for  every  transaction. 
Consequently  the  original  equality  between  left-hand  balances 
and  right-hand  balances  is  continuously  maintained.  This  con- 
stant equality  is  an  important  clerical  advantage  because  of  the 
test  for  numerical  accuracy  which  it  furnishes. 

The  essence  of  the  double-entry  system  of  accounts  consists 
in  the  separation  of  the  members  of  the  equation,  assets  = 
equities,  and  the  maintenance  of  this  classification  and  its  equality. 
Thus  the  double-entry  method  is  more  than  an  arbitrary  device 
for  recording  facts.  The  first  step  in  the  interpretation  of  ac- 
counting data  is  made  in  forming  the  two  fundamental  classes. 
In  the  double-entry  system  the  left-hand  side  of  all  accounts  is 
called  the  debit  side,  the  right-hand  is  called  the  credit  side. 


34  PRINCIPLES  OF  ACCOUNTING 

The  simplest  rule  for  debit  and  credit  is  based  directly  upon  the 
fundamental  equation.  Debit  indicates  additions  to  assets  and 
subtractions  from  equities;  credit  indicates  additions  to  equities 
and  subtractions  from  assets.  The  terms  debit  and  credit  have 
no  other  important  significance  as  used  in  modern  accounts. 

In  the  next  chapter  will  be  explained  the  construction  of  the 
special  types  of  accounts  necessary  to  record  certain  classes  and 
phases  of  the  assets  and  equities  which  appear  in  the  process  of 
business  operation. 


Ill 

THE  CONSTRUCTION  or  SUPPLEMENTARY  ACCOUNTS 

IT  was  noted  in  Chapter  I  that  an  adequate  system  of  ac- 
counts for  a  business  enterprise  should  furnish  a  record  of  the 
history  of  operation  as  well  as  the  facts  necessary  to  a  statement 
of  the  concern's  momentary  financial  status.  The  balance  sheet 
accounts,  which  were  explained  in  the  last  chapter,  show  the 
condition  of  the  enterprise  at  the  beginning  of  any  given  period 
of  operation ;  but  because  of  the  complexity  of  the  business  pro- 
cess many  additional  accounts  are  necessary  in  which  to  record 
systematically  the  various  transactions  of  the  operating  period 
which  may  affect  the  original  equation.  Not  only  are  there  some 
accounts  necessary  which  are  not  in  the  first  balance  sheet  but 
which  become  incorporated  in  succeeding  financial  statements, 
but  special  groups  of  accounts  are  needed  which  never  appear  in 
a  statement  of  assets  and  equities.  In  the  present  chapter  the 
construction  of  the  important  types  of  these  supplementary 
accounts  will  be  explained. 

CURRENT  ASSET  ACCOUNTS 

It  was  stated  in  the  last  chapter  that  the  operation  of  a  business 
enterprise  may  be  conceived  as  the  combination  of  a  more  or  less 
considerable  variety  of  purchased  commodities  and  services  with 
the  services  of  the  owners  themselves  for  the  purpose  of  produc- 
ing some  other  commodity  or  service  for  sale.  Now  it  is  obvious 
that,  in  the  case  of  the  A.  B.  Co.  (referring  again  to  this  supposi- 
titious concern)  or  any  other  enterprise,  there  will  necessarily 
be  involved  in  production  other  types  of  commodities  and  serv- 
ices than  those  the  firm  has  on  hand  at  the  moment  operation 
begins.  The  assets  of  the  A.  B.  Co.  listed  in  the  preceding  chap- 

35 


36  PRINCIPLES  OF  ACCOUNTING 

ter  were  land,  building,  equipment,  materials  and  cash.  The 
first  three  of  these  items  prefixed  assets,  representing  the  more  or 
less  permanent  equipment  of  the  enterprise.  The  only  current 
assets  on  hand,  then,  are  raw  materials  and  cash.  If  this  is  a 
typical  manufacturing  enterprise,  other  kinds  of  current  commod- 
ities and  services  will  be  necessary  in  the  process  of  producing 
the  finished  article.  Labor  services  are  necessary  in  practically 
all  productive  processes;  and  certainly  the  A.  B.  Co.  will  be 
obliged  to  purchase  labor  from  time  to  time  if  operation  is  to 
proceed.  The  services  of  insurance  and  advertising  will  doubtless 
be  secured ;  it  will  be  necessary  to  buy  stationery,  fuel  and 
other  supplies.  The  number  of  classes  of  such  commodities  and 
services  required  in  any  case  will,  of  course,  depend  upon  the 
needs  of  the  particular  enterprise  under  consideration. 

The  question  arises  as  to  how  accounts  with  supplies,  fuel, 
insurance,  etc.,  will  fit  into  the  scheme  of  asset  and  equity  accounts 
thus  far  outlined.  What  is  the  nature  of  these  items?  As  the 
student  easily  becomes  confused  at  this  point  it  is  desirable  to 
answer  these  questions  with  considerable  care. 

These  items  at  the  moment  of  purchase  fall  into  the  category, 
assets.  This  is  fairly  obvious  in  the  case  of  such  tangible  items 
as  coal,  stationery,  etc.  Coal  in  the  bin  is  clearly  just  as  much 
an  asset  as  show  cases  and  other  store  fixtures.  Further,  as  was 
noted  early  in  Chapter  II,  the  asset  concept  may  apply  with 
equal  propriety  to  material  and  immaterial  items.  All  things 
for  which  one  must  pay  are  assets  at  the  moment  of  purchase, 
whether  the  thing  secured  be  a  commodity  or  a  right  to  services. 
Hence,  services  such  as  insurance,  advertising,  etc.,  in  so  far  as 
such  items  represent  future  goods,  are  assets.  They  are  all 
economic  goods  and  are  so  considered  by  the  business  man. 
When  a  proprietor  buys  insurance  service,  for  example,  and  pays 
cash,  he  expects  to  receive  a  value  equivalent  for  his  expenditure, 
just  as  in  the  case  of  buying  a  machine,  a  building,  or  any  other 
item  of  physical  property.  Valuable  services  are  to  him  just  as 
truly  asset  items  as  are  valuable  commodities.  If  one  approached 
the  owner  of  some  business  with  the  idea  of  buying  him  out,  what 
would  the  prospective  seller  include  in  a  statement  of  his 
property  ?  Certainly  he  would  include  fuel,  stationery  and  other 
supplies  on  hand,  as  well  as  building,  fixtures  and  merchandise. 


CONSTRUCTION  OF  SUPPLEMENTARY  ACCOUNTS       37 

And  further,  if  there  are  any  insurance  services,  advertising  serv- 
ices, or  any  other  valuable  services  or  rights  which  have  been 
purchased  but  are  not  yet  consumed,  or  from  which  the  entire 
benefit  has  not  yet  been  exhausted,  the  balances  of  such  items 
would  be  listed  as  assets. 

There  are  important  reasons  for  distinguishing  the  current 
assets  from  the  more  permanent  forms  of  property,  and  it  is  not 
intended  here  to  minimize  or  obliterate  the  distinction  between 
the  two  groups.  Nevertheless  it  should  be  recognized  that  the 
general  class,  assets,  covers  all  these  current  items  as  purchased. 
It  cannot  be  too  emphatically  urged  that  as  far  as  the  structure 
of  the  accounts  is  concerned  there  is  no  distinction  whatever 
between  the  accounts  used  to  record  current  assets  and  the 
balance  sheet  asset  accounts  described  in  Chapter  II.  The 
purchase  of  coal  can  be  conceived  as  exactly  analogous  to  the 
purchase  of  real  estate,  and  the  entries  representing  such  a  pur- 
chase are  made  according  to  the  same  rules  in  either  case.  The 
difference  between  buildings  and  fuel  is  not  that  one  is  an  asset 
and  the  other  an  expense  (see  the  following  section)  or  asset  con- 
sumed ;  the  only  line  that  can  be  drawn  is  the  relative  permanence 
of  the  former  as  compared  with  the  latter  item.  A  shipment  of 
coal  may  be  largely  consumed  in  a  month ;  a  building  may  last 
twenty  years.  The  distinction  made  in  economic  theory  between 
circulating  and  fixed  capital  follows  much  the  same  line  of  de- 
marcation as  this  distinction  between  current  and  fixed  assets. 

How  far  the  classification  of  current  assets  should  be  carried 
in  the  accounts  in  any  given  case  is  purely  a  matter  of  conven- 
ience, depending  upon  the  nature  of  the  particular  enterprise 
under  consideration  and  the  needs  and  purposes  of  the  manage- 
ment. In  some  cases  these  items  may  be  grouped  under  a  few 
heads ;  in  others  a  long  list  of  accounts  is  necessary.  For  pur- 
poses of  illustration  it  will  be  assumed  that  the  A.  B.  Co.  has  four 
accounts  in  which  to  record  t!he  purchases  of  current  assets : 
Supplies,  Fuel,  Insurance,  and  Miscellaneous  Assets.  This 
would  in  most  cases  be  a  very  inadequate  list  of  such  accounts 
for  a  manufacturing  enterprise,  and  it  must  be  understood  that 
these  accounts  are  given,  not  as  a  proper  classification  for  an 
actual  business,  but  merely  to  make  the  discussion  more  con- 
crete. According  to  the  above  analysis  these  accounts  should 


38  PRINCIPLES  OF  ACCOUNTING 

be  opened  in  exactly  the  same  way  as  the  asset  accounts  described 
in  the  preceding  chapter  —  the  left-hand  column  being  used  for 
additions,  the  right-hand  column  for  subtractions,  thus  : 


ADDITIONS 


SUBTRACTIONS 


Supplies 


Fuel 


Insurance 


Miscellaneous  Assets 


Then  if  coal  were  purchased  for  cash, 
would  be  recorded  by  a  left-hand  —  or  debit 


the  transaction 
entry  of  $60  in 


CONSTRUCTION   OF  SUPPLEMENTARY  ACCOUNTS 


39 


the  Fuel  account  (representing  the  addition  to  an  asset)  and  a 
right-hand  —  or  credit  —  entry  of  the  same  amount  in  the  Cash 
account  (representing  the  subtraction  from  an  asset).  All  pur- 
chases of  current  assets,  whether  commodities  or  services,  would 
be  similarly  recorded  in  the  debit  columns  of  the  proper  accounts. 

EXPENSE  AND  REVENUE  ACCOUNTS 

The  point  was  made  in  Chapter  I  that  one  important  purpose 
of  the  financial  records  is  to  show  the  increase  or  decrease  in  the 
equities  in  a  given  period,  and  the  process  whereby  this  change 
is  attained.  Because  of  the  complexity  of  the  actual  business 
process  it  is  impossible  to  record  the  changes  in  ownership  directly 
in  the  equity  accounts  as  they  occur.  Special  groups  of  accounts 
are  necessary  in  which  certain  phases  of  the  assets  and  equities 
are  recorded  as  the  facts  are  ascertained,  and  later  the  informa- 
tion shown  by  these  special  accounts  is  gathered  together  and  its 
net  result  incorporated  in  the  balance  sheet  equity  accounts. 

The  positive  phase  of  the  equities  which  arises  during  business 
operation  is  revenue.  Revenue  represents  the  sale  of  product,  or, 
more  exactly,  the  additions  to  the  equities  which  occur  through 
the  sale  of  the  owners'  services  embodied  in  the  finished  product. 
Whether  the  product  of  the  firm  in  question  be  a  commodity  or 
a  service,  the  sale  of  the  commodity  or  service  gives  rise  to  rev- 
enue. It  is  impossible  in  practice,  however,  to  determine  all 
expirations  of  assets  which  have  occurred  in  the  process  of  pro- 
duction concurrently  with  the  additions  to  assets  made  from  the 
sale  of  product.  Such  expirations  are  those  which  are  due  to 
business  operation  and  the  passage  of  time,  for  example :  the 
consumption  of  coal  in  the  furnace ;  the  depreciation  of  buildings. 
Consequently  revenue  from  the  sale  of  product  usually  repre- 
sents gross  rather  than  net  additions  to  the  equities.  It  becomes 
necessary,  then,  at  certain  intervals  to  subtract  from  the  revenues 
the  decreases  in  assets  not  previously  recognized  in  the  accounts. 
This  can  be  done  by  making  subtractions  from  the  revenue  ac- 
counts directly,  or  these  subtractions  may  be  listed  in  distinct 
expense  accounts,  in  which  case  the  net  change  in  the  equities 
may  be  determined  by  combining  the  amounts  listed  in  both  of 
these  groups  of  accounts. 


40  PRINCIPLES  OF  ACCOUNTING 

If  the  necessary  commodities  and  services  which  a  firm  acquires 
were  imperishable  (in  the  economic  as  well  as  the  physical  sense), 
then  the  sale  of  product  would  give  rise  to  a  net  increase  in 
ownership,  for  no  deductions  would  be  necessary.  Although  it 
is  difficult  indeed  to  discover  an  actual  enterprise  which  even 
approximates  this  condition,  a  consideration  of  such  a  case  will 
serve  to  throw  some  light  upon  the  nature  of  the  important  con- 
cepts of  revenue,  expense  and  net  revenue. 

A  certain  individual  has  $5,000  on  deposit  in  a  savings  bank. 
His  business,  it  might  be  said,  consists  in  furnishing  the  use  of 
capital.  A  balance  sheet  for  the  enterprise  would  appear  as 
follows : 

ASSETS  EQUITIES 

Cash $5,ooo    An  Individual,  Ownership  .     $5,000 

The  bank,  it  will  be  assumed,  pays  four  per  cent  interest  on  de- 
posits. At  the  end  of  a  year  $200  in  interest  has  been  earned. 
The  balance  sheet  would  now  appear : 

ASSETS  EQUITIES 

Original  Cash $5,ooo      An  Individual,  Original 

New  Cash 200          Ownership $5,ooo 

An  Individual,  New 

Ownership 200 

Total $5,200  Total $5,200 

In  this  case  the  increase  in  assets,  $200,  means  an  increase  in 
equities  of  an  equal  amount.  Revenue,  then,  is  net,  for  no  ex- 
pirations of  original  capital  are  involved.  The  entire  amount, 
$200,  constitutes  a  payment  for  capital  service  (the  pure  service 
of  the  proprietor) ;  and  since  the  investment  remains  intact 
this  amount  constitutes  at  once  a  net  increase  in  assets  and  a  net 
increase  in  equities. 

The  typical  business  enterprise,  however,  is  not  at  all  repre- 
sented by  such  a  case.  Even  a  firm  engaged  primarily  in  loaning 
capital  will  usually  have  certain  costs,  such  as  rent,  labor,  station- 
ery, etc.,  incident  to  operation.  And  in  a  manufacturing  or  retail 
business  from  eighty  to  ninety  per  cent  of  the  assets  received 
from  the  sale  of  product  may  be  necessary  to  replace  the  outlays 


CONSTRUCTION  OF  SUPPLEMENTARY  ACCOUNTS       41 

required  in  the  production  of  that  product.  This  means,  in 
other  words,  that  large  deductions  must  be  made  from  gross 
revenue,  through  the  expense  accounts,  before  the  net  return  to 
ownership  is  determined. 

Expense  and  revenue  accounts,  therefore,  may  properly  be 
considered  as  subsidiary  equity  accounts,  recording  gross  addi- 
tions to  and  gross  subtractions  from  the  equities ;  and  the  con- 
struction of  such  accounts  is  analogous  to  that  of  the  equity 
accounts  described  in  the  preceding  chapter.  Items  of  revenue, 
which  constitute  gross  additions  to  the  equities,  are  listed  in  the 
right-hand  column  of  the  revenue  accounts.  Items  of  expense 
are  listed  in  the  left-hand  column  of  the  expense  accounts  because 
these  amounts  constitute  subtractions  from  revenue. 

It  is  important  to  note  that  the  concept  of  expense  can  be  most 
adequately  denned  in  relation  to  revenue.  Revenue  represents 
gross  additions  to  equities;  expense  represents  subtractions  from 
revenue.  This  relation  can  be  shown  graphically,  thus : 

SUBTRACTIONS  ADDITIONS 

Revenue 


Expense 


Then,  in  applying  the  rule  for  debit  and  credit  entries  given  in 
Chapter  II,  it  should  be  recognized  that  a  debit  entry  in  an  ex- 
pense account  is  a  subtraction  from  equities  in  the  sense  that  it  is 
first  a  subtraction  from  revenue,  which  in  turn  represents  gross 
additions  to  equities. 

It  will  doubtless  occur  to  the  student  that  all  expense  and 
revenue  items  might  be  grouped  logically  under  one  account, 
the  expense  items  being  listed  in  the  left-hand  column,  the  revenue 
items  in  the  right-hand  column.  That  is,  expense  and  revenue 
accounts  are  really  one-column  accounts,  minus  equity  items 
appearing  in  one  case,  and  plus  equity  items  in  the  other.  The 


42  PRINCIPLES   OF  ACCOUNTING 

net  balance  of  such  a  composite  account  would  represent  the  net 
change  in  the  equities.  The  use  of  such  an  account  will  be  dis- 
cussed in  a  later  chapter.  When  expense  and  revenue  items  are 
segregated  in  special  accounts,  however,  the  two-column  arrange- 
ment is  preserved  in  each  distinct  account  for  clerical  convenience 
in  making  transfer  entries. 

The  expense  and  revenue  accounts  may  be  subdivided  for 
statistical  purposes  almost  indefinitely.  This  is  one  of  the  points 
at  which  a  system  of  accounts  is  capable  of  great  extension. 
Each  particular  type  of  expense  may  be  listed  in  a  distinct  account, 
and  these  accounts  may  be  grouped  under  several  main  heads. 
Similarly  the  special  revenue  accounts  in  an  enterprise  like  a 
railroad  company,  for  example,  may  be  very  numerous.  The 
classification  of  expense  and  revenue  accounts  is  one  of  the  most 
important  questions  arising  in  the  construction  of  a  system  of 
accounts  for  some  specific  enterprise.  For  the  present,  however, 
it  will  be  sufficient  for  the  student  to  grasp  the  general  principles 
underlying  the  construction  of  such  accounts ;  and  hence  the 
detail  questions  of  classification  will  not  be  discussed  at  this 
point.  The  A.  B.  Co.,  it  will  be  assumed,  uses  but  two  such 
accounts,  one  for  the  expense  items  and  one  for  revenues.  This 
would  be  an  inadequate  system  in  practice  for  any  but  very 
simple  situations. 

An  analysis  of  a  few  transactions  involving  expense  and  revenue 
items  will  show  concretely  the  nature  of  such  accounts  and  the 
method  of  making  the  entries.  The  A.  B.  Co.,  for  example,  sells 
goods  for  $1,500,  cash.  This  is  an  illustration  of  a  revenue  trans- 
action. It  would  be  recorded  by  a  debit  entry  of  $1,500  in  the 
Cash  account  —  an  addition  to  assets,  and  a  credit  entry  of  $1,500 
in  the  Revenue  account  —  a  gross  addition  to  equities.  If  now 
it  were  possible  to  discover  immediately  the  expenses  involved 
in  producing  this  item  of  revenue  these  expenses  might  be  at  once 
recorded  and  the  amount  of  net  revenue  shown.  Right-hand  - 
or  credit  —  entries  would  be  made  in  the  various  asset  accounts 
affected  to  represent  the  subtractions  from  assets,  and  left-hand 
—  or  debit  —  entries  for  the  same  amounts  in  the  Expense  ac- 
count to  represent  the  subtractions  from  revenue.  If,  for  ex- 
ample, it  is  discovered  that  coal  has  been  consumed  to  the  amount 
of  $10,  this  situation  would  be  recorded  by  a  credit  entry  of  $10 


CONSTRUCTION  OF   SUPPLEMENTARY  ACCOUNTS        43 

in  the  Fuel  account  and  a  debit  entry  of  $10  in  the  Expense  ac- 
count. 

In  many  cases  a  service  or  commodity  purchased  becomes  an 
expense  before  it  appears  as  an  asset  in  the  accounts.  A  purchase 
of  postage  stamps,  for  example,  may  be  utilized  entirely  on  the 
day  of  purchase  and  hence  never  exist  in  the  accounts  as  an  asset. 
If  the  amount  were  $5  the  transaction  would  then  be  recorded 
by  a  debit  entry  of  $5  directly  in  the  Expense  account,  and  a 
credit  entry  of  the  same  amount  in  the  Cash  account.  The 
item  has  passed  on  in  the  operation  of  the  business  and  cannot 
now  be  considered  an  asset.  In  strict  logic,  however,  these 
entries  are  really  a  summary  of  two  independent  happenings : 
(i)  an  exchange  of  assets  —  cash  for  stamps  ;  (2)  an  expiration 
of  an  asset  and  a  subtraction  from  revenue.  If  a  complete  record 
of  this  situation  were  made  the  entries  would  be  as  follows  :  (i)  a 
debit  entry  in  the  Miscellaneous  Assets  account  and  a  credit 
entry  in  the  Cash  account;  and  (2)  a  credit  entry  in  the  Mis- 
cellaneous Assets  account  and  a  debit  entry  in  the  Expense 
account.  In  practice,  however,  it  would  not  be  expedient  to 
carry  this  analysis  into  the  accounts. 

Similarly,  if  the  A.  B.  Co.  hires  laborers  for  a  week  and  pays 
them  $150  in  cash  at  the  end  of  this  period,  these  services  do  not 
exist  as  independent  assets  but  have  passed  on  in  the  business 
process  before  payment  is  made.  Hence  the  transaction  in 
practice  would  be  recorded  by  a  debit  entry  of  $150  in  the  Ex- 
pense account  and  a  credit  entry  of  the  same  amount  in  the  Cash 
account.  But  if  wages  or  salaries  are  prepaid  in  any  case  for  a 
considerable  interval  it  should  be  recognized  that  the  debit 
entries  involved  represent,  not  subtractions  from  revenue  but 
additions  to  assets.  The  problem  of  classifying  the  accounts 
involved  in  these  and  similar  situations  will  be  further  considered 
in  a  later  section  of  this  chapter. 

SPECIAL  EQUITY   ACCOUNTS 

In  addition  to  the  expense  and  revenue  accounts  several  other 
types  of  supplementary  equity  accounts  may  be  necessary,  in  the 
case  of  the  typical  enterprise,  if  the  financial  records  are  to  show 
a  reasonably  complete  statement  of  the  changes  in  ownership  due 


44  PRINCIPLES  OF  ACCOUNTING 

to  business  operation.  The  net  balance  of  the  expense  and 
revenue  accounts  is,  as  already  noted,  net  revenue  —  or,  if  the 
enterprise  has  been  unsuccessful,  net  loss.  It  is  desirable  in  some 
cases  to  record  this  amount,  after  it  is  once  determined,  in  a 
special  account.  Such  an  account,  in  the  case  of  net  revenue, 
represents  the  net  increase  in  ownership  during  the  period  of 
operation  under  consideration ;  in  the  case  of  net  loss  such  an 
account  shows  the  decrease  in  the  equities  for  the  period.  En- 
tries in  these  accounts  are  made  in  exactly  the  same  manner  as 
are  the  entries  in  the  balance  sheet  equity  accounts  already  de- 
scribed. Items  of  net  revenue  are  transferred  to  the  credit 
column  of  the  Net  Revenue  account;  items  of  net  loss  are 
entered  in  the  debit  column  of  this  account  (or  in  the  debit 
column  of  a  distinct  loss  account). 

It  should  be  noticed  that  in  addition  to  the  balance  from  the 
expense  and  revenue  accounts  certain  items  of  net  loss  and  net 
gain  may  arise  which  require  entries  directly  in  special  equity 
accounts.  Suppose  some  unforeseen  calamity  results  in  the  de- 
struction of  a  portion  of  the  assets  of  an  enterprise.  Such  a 
happening  constitutes  a  net  subtraction  from  assets  and  hence 
a  net  subtraction  from  ownership.  If,  for  statistical  purposes, 
such  items  are  set  up  under  a  special  head  the  resulting  account 
is  a  negative  equity  account,  recording  certain  subtractions  from 
the  equities  which  for  the  time  being  are  not  deducted  from  the 
amounts  appearing  in  the  main  equity  accounts.  Suppose,  for 
example,  coal  to  the  value  of  $100  is  stolen.  This  transaction 
could  be  recorded  by  a  credit  entry  of  $100  in  the  Fuel  account 
and  an  equal  debit  entry  in  a  special  loss  account.  It  is  evident 
that  such  a  subtraction  from  equities  is  quite  distinct  from  an 
expense  item  —  a  subtraction  from  revenue.  The  ton  of  coal 
burned  in  the  manufactory's  furnace  gives  rise  to  an  expense; 
although  in  a  broad  sense  it  is  an  exchange  of  one  asset  for  an- 
other, for  normally  the  proceeds  from  the  sale  of  product  will 
recoup  the  firm  fqr  all  such  expirations.  But  the  ton  of  coal 
stolen  is  an  actual  loss,  no  valuable  consideration  being  received 
in  exchange ;  and  hence  such  an  item  constitutes  a  net  subtrac- 
tion from  the  equities.  It  is  not  intended  to  elaborate  at  this 
point  the  importance  of  the  distinction  between  a  loss  and  an 
expense.  For  the  present  it  is  sufficient  to  note  that  the  accounts 


45 

in  either  case  are  constructed  as  subsidiary  equity  accounts,  and 
the  entries  are  made  according  to  the  same  rules. 

Similarly,  a  donation,  or  any  other  accidental  or  extraordinary 
increase  in  assets,  gives  rise  to  an  immediate  net  increase  in  equi- 
ties ;  no  expense  deductions  are  involved  in  such  an  increase. 
If,  for  example,  a  factory  site  were  donated  to  the  A.  B.  Co.  by 
an  interested  municipality,  the  transaction  would  be  recorded 
by  a  debit  entry  in  the  Land  account,  as  in  the  case  of  any  asset 
increase,  and  a  credit  entry  either  in  the  A.  B.  Co.  account  or  in 
some  special  proprietary  account  (for  example,  Surplus  from 
Donations).  Since  proprietorship  is  the  residual  equity  all 
special  accounts  in  which  actual  losses  or  gains  are  recorded  can 
be  classed  as  subsidiary  proprietary  accounts. 

Another  occasion  for  the  use  of  special  equity  accounts  arises 
in  connection  with  the  distribution  of  net  revenue  among  the 
various  equities.  In  a  partnership  the  partners'  "personal"  or 
"drawing"  accounts  are  commonly  used  to  record  withdrawals 
from  either  income  or  original  investment.  If,  for  example,  A, 
a  partner  in  a  certain  enterprise,  withdraws  in  cash  net  revenue 
amounting  to  $500,  the  transaction  would  be  recorded  by  a 
credit  entry  of  $500  in  the  Cash  account  and  a  debit  entry  of 
$500  in  the  A,  Personal  account.  In  the  incorporated  enterprise, 
where  such  withdrawals  take  the  form  of  interest  and  dividends, 
special  accounts  are  necessary  to  record  the  payments  —  sub- 
tractions from  equities  —  made  to  the  various  classes  of  security- 
holders.  It  will  be  assumed  that  the  A.  B.  Co.  makes  use  of  two 
such  accounts,  Interest  and  A.  B.  Co.,  Current.  The  Interest 
account  is  to  be  used  to  record  all  accruals  to  the  contractual 
equities  —  in  this  case  represented  by  mortgages  and  notes ; 
and  it  is  the  function  of  the  A.  B.  Co.,  Current  account  to  show 
all  proprietary  earnings  and  withdrawals.  The  relation  between 
these  special  accounts  and  the  Net  Revenue  account  is  shown 
in  the  exhibit  at  top  of  page  46. 

If,  then,  $i  ,050  (interest  for  six  months)  were  paid  to  the  holders 
of  mortgages  against  the  assets  of  the  enterprise  the  transaction 
would  be  recorded  by  a  credit  entry  of  $1,050  in  the  Cash  account 
(a  subtraction  from  an  asset)  and  a  debit  entry  of  $1,050  in  the 
Interest  account  (a  subtraction  from  an  equity  —  net  revenue). 
Similarly,  if  the  proprietors  decided  to  withdraw  earnings  amount- 


PRINCIPLES  OF  ACCOUNTING 


SUBTRACTIONS  ADDITIONS 

Net  Revenue 


Interest 


A.  B.  Co.,  Current 


ing  to  $3,000  the  transaction  would  be  recorded  by  a  credit  entry 
of  $3,000  in  the  Cash  account  and  a  debit  entry  of  the  same  amount 
in  the  A.  B.  Co.,  Current  account.  A  great  variety  of  simple 
and  complex  transactions  involving  additions  to  or  subtractions 
from  net  revenue  and  its  subsidiary  heads  may  occur  in  business 
practice.  Nevertheless  the  rules  for  making  debit  and  credit 
entries  as  explained  in  Chapter  II  apply  logically  to  all  cases. 

Special  accounts  are  commonly  used  to  show  the  accumula- 
tions of  net  proprietary  revenue  invested  in  the  business.  The 
Surplus  account  is  used  for  this  purpose.  Such  an  account  is 
simply  a  special  proprietary  account  and  is  constructed  in  the 
same  way  as  any  other  equity  account.  The  term  deficit  is  used 
to  designate  accumulated  net  loss,  and  the  account  in  which 
such  items  are  recorded  is  the  Deficit  account.  The  relation 
between  the  original  proprietorship,  Surplus  and  Deficit  accounts 
can  be  shown  thus : 

SUBTRACTIONS  ADDITIONS 

A.  B.   Co. 


Deficit 


Surplus 


CONSTRUCTION  OF  SUPPLEMENTARY  ACCOUNTS       47 

The  Surplus  account  in  practice  may  have  a  number  of  important 
subdivisions.  The  special  loss  and  gain  accounts  mentioned 
above  can  be  considered  as  examples  of  subsidiary  deficit  and 
surplus  accounts,  provided  the  amounts  involved  are  treated  as 
adjustments  of  original  proprietorship  rather  than  of  net  revenue. 
In  Chapter  XIII  the  various  surplus  accounts  will  be  discussed 
in  some  detail. 

One  other  group  of  equity  accounts  —  those  recording  current 
liabilities  —  should  be  mentioned.  In  addition  to  liabilities 
such  as  ordinary  accounts  payable  —  which  arise  through  the 
purchase  of  raw  materials  and  other  assets  on  credit  —  accrued 
items  of  wages,  interest  and  taxes  are  sometimes  set  up  in  special 
accounts.  All  of  these  accounts  are  constructed  as  are  the  bal- 
ance sheet  equity  accounts  —  the  right-hand  column  being  used 
for  additions,  the  left-hand  column  for  subtractions.  Any  firm 
which  does  not  adopt  a  strictly  cash  basis  for  its  business  rela- 
tions will  require  several  such  accounts.  Specific  examples  will 
not  be  considered  at  this  point,  however,  for  the  use  of  such  ac- 
counts can  be  more  conveniently  explained  in  later  chapters. 


VALUATION  ACCOUNTS 

Almost  any  asset  or  equity  account  may  have  a  subsidiary 
account.  Whenever  it  is  desired  for  some  reason  to  take  special 
cases  of  subtractions  from  either  an  asset  or  an  equity  item  and 
place  such  subtractions  under  a  special  head,  the  new  account 
simply  represents  a  part  of  the  main  account,  or  is,  in  other 
words,  subsidiary  to  the  main  account.  Such  accounts  are 
usually  called  valuation  accounts. 

There  are  several  reasons  for  the  use  of  valuation  accounts. 
In  the  case  of  a  fixed  asset,  such  as  a  building,  it  may  be  thought 
desirable  to  preserve  in  one  account  the  original  cost  figures  and 
to  use  a  special  account  to  show  the  subtractions  from  this  asset 
which  are  due  to  business  operation  and  the  passage  of  time. 
Such  an  account  may  be  called,  Allowance  for  Depreciation  of 
Building.1  If,  for  example,  it  were  discovered  that  the  building 
of  the  A.  B.  Co.  had  declined  in  value  during  a  certain  period  of 

1  Cf.  Cole,  Accounts,  Their  Construction  and  Interpretation. 


48 


PRINCIPLES  OF  ACCOUNTING 


operation,  $600,  this  transaction  would  be  recorded  by  a  right- 
hand  entry  of  $600  in  the  Allowance  for  Depreciation  of  Building 
account  and  a  left-hand  entry  in  the  Expense  account.  The 
first  entry  represents  the  subtraction  from  the  asset,  but  instead 
of  being  recorded  directly  in  the  Building  account  this  sub- 
traction is  set  up  in  a  subsidiary  valuation  account ;  or,  in  other 
words,  a  credit  entry  in  a  valuation  account  is  substituted  for 
a  credit  in  the  asset  account.  The  second  entry  represents  the 
subtraction  from  revenue  due  to  the  expiration  of  this  asset  in 
business  operation.  The  relation  between  the  Building  account 
and  its  subsidiary  can  be  suggested  thus : 

ADDITIONS  SUBTRACTIONS 

Building 


Allowance   for   Depreciation 
of  Building 


Many  cases  of  asset  valuation  accounts  are  met  with  in  ac- 
counting practice.  Since  such  accounts  show  credit  balances 
they  are  sometimes  confused  with  the  equities.  The  importance 
of  avoiding  such  a  confusion  can  hardly  be  overemphasized,  for 
there  is  clearly  no  relation  between  a  positive  equity  balance  and 
a  subtraction  from  an  asset.  The  use  of  such  accounts  and  their 
significance  in  the  accounting  statements  will  be  further  dis- 
cussed later  in  the  text. 

In  connection  with  equity  accounts  which  represent  the  secu- 
rities of  incorporated  companies  valuation  accounts  are  fre- 
quently used.  Securities  are  commonly  maintained  in  the  ac- 
counts at  par  —  the  nominal  value.  Since  the  actual  amount 
of  ownership  represented  by  a  security  very  often  is  more  or  less 
than  the  stated  par  value,  subsidiary  accounts  are  necessary  to 
show  the  difference.  Thus,  capital  stock  may  be  issued  at  $75 
per  share  although  the  formal  capitalization  is  $100  per  share. 


CONSTRUCTION  OF  SUPPLEMENTARY  ACCOUNTS       49 

If  the  Capital  Stock  account  is  used  to  record  the  par  value,  a 
valuation  account,  Discount  on  Stock,  must  be  opened,  in  which 
is  shown  the  amount  of  the  discount.  Such  an  account  simply 
shows  an  offset  to  an  overstated  equity.  The  Deficit  account 
mentioned  in  the  preceding  section  is  really  a  valuation  account, 
its  function  being  to  show  the  accumulated  net  decrease  in  the 
proprietor's  equity. 

There  is  nothing  about  valuation  accounts  that  invalidates 
the  explanation  of  the  double-entry  system  thus  far  outlined. 
Each  valuation  account  is  so  constructed  as  to  preserve  the 
balance  of  the  main  account,  be  it  an  asset  or  an  equity  account, 
in  the  proper  column.  Such  accounts  are  further  illustration  of 
the  general  scheme  of  using  additional  columns  for  minus  items 
rather  than  making  the  actual  subtractions ;  though  in  this  case 
entirely  distinct  accounts  are  used  for  the  negative  items.  The 
need  in  particular  cases  for  preserving  original  figures  in  the  ac- 
counts is  the  legitimate  excuse  for  such  a  procedure. 

In  this  section,  as  in  the  preceding,  it  is  not  feasible  to  do  more 
than  mention  these  special  subsidiary  accounts.  Yet  although 
an  endeavor  has  been  made  to  reduce  the  discussion  to  its  simplest 
terms  it  has  been  impossible  to  avoid  introducing  certain  expres- 
sions and  concepts  with  which  the  student  will  not  be  entirely 
familiar  until  much  later ;  as  in  many  other  subjects  the  student's 
mastery  of  ideas  which  are  necessarily  brought  in  at  the  beginning 
is  not  complete  until  the  entire  field  has  been  covered.  The  way 
in  which  such  special  accounts  fit  into  the  general  structure  of 
the  double-entry  system  has,  however,  been  suggested ;  and  it 
should  appear  fairly  evident  at  this  point  that  the  general  rules 
involved  in  the  construction  of  a  whole  system  of  accounts  — 
those  representing  the  historical  situation  as  well  as  those  showing 
the  financial  condition  of  an  enterprise  at  given  moments  of  time 
—  are  essentially  those  stated  in  Chapter  II.  The  fundamental 
consideration  controlling  the  construction  of  the  historical  as 
well  as  the  balance  sheet  accounts  is  the  preservation  of  the  clas- 
sification, assets  and  equities.  In  all  valuation  and  other  sub- 
sidiary accounts,  then,  debit  and  credit  entries  have  essentially 
the  same  possible  meanings  as  in  the  main  asset  and  equity  ac- 
counts. 


SO  PRINCIPLES  OF  ACCOUNTING 


THE   CLASSIFICATION   OF   ACCOUNTS 

The  classification  of  accounts  that  has  been  presented  thus  far 
in  the  text  has  recognized  only  pure  accounts  —  accounts,  that  is, 
which  show  in  each  case  but  one  of  the  important  classes  of  the 
balance  sheet,  or  some  phase,  positive  or  negative,  of  one  of 
these  classes.  In  other  words,  each  of  the  important  accounting 
concepts  —  asset,  equity,  expense,  revenue,  etc.  —  has  been  at- 
tached to  a  distinct  group  of  accounts.  While  this  classification 
is  of  primary  importance  in  that  it  furnishes  a  rational  basis  for 
the  explanation  of  the  essential  nature  of  a  system  of  double- 
entry  accounts,  it  should  now  be  recognized  that  no  set  of  ac- 
counts in  actual  practice  can  be  expected  to  follow  such  a  grouping 
exactly.  Brief  consideration  will  be  given  at  this  point  to  some 
of  the  principal  difficulties  involved  in  account  classification.1 

As  already  noted,  the  current  assets  merge  with  the  expense 
items  at  certain  points ;  or,  in  other  words,  some  outlays  in  busi- 
ness practice  are  of  such  a  nature  that  they  may  be  classed,  with 
almost  equal  propriety,  as  either  asset  or  expense  items.  Some 
commodities  and  services  are  so  transitory  in  character  as  to  con- 
stitute expense  almost  at  the  moment  of  purchase ;  that  is,  al- 
though any  valuable  item  is  logically  an  asset  as  purchased,  it 
may  become  an  expense  shortly  after  —  or  even  before  - —  it  is 
convenient  to  record  it  in  the  accounts.  The  cash  purchase  of 
advertising  services,  for  example,  may  be  conceived  in  the  first 
instance  as  an  exchange  of  assets ;  hence  the  entries  involved 
may  be  said  to  represent  an  addition  to  one  asset  and  a  sub- 
traction from  another.  If,  then,  the  accounts  affected  are  de- 
fined in  terms  of  the  logical  classes  involved  in  the  transaction 
at  the  moment  of  purchase,  it  can  be  affirmed, "with  reason,  that 
both  accounts  are  asset  accounts.  On  the  other  hand,  if  the  pay- 
ment made  is  for  services  covering  a  very  short  period,  the  trans- 
action may  logically  be  viewed,  not  from  the  moment  of  purchase 
but  from  the  moment  of  expiration ;  and  from  this  standpoint 
it  can  be  said  that  the  debit  entry  represents  an  expense  —  a 
deduction  from  revenue.  If  the  accounts  involved  are  now 
defined  in  terms  of  the  logical  classes  existing  at  the  moment 

1  "Account  classification"  means  here,  not  detail  classification  for  managerial 
purposes,  but  general  classification  in  terms  of  fundamental  concepts. 


CONSTRUCTION  OF   SUPPLEMENTARY  ACCOUNTS       51 

the  item  has  expired,  it  may  with  reason  be  said  that  the  account 
in  which  the  left-hand  item  is  recorded  is  an  expense  account. 
Or  if  payment  is  made  concurrently  with  the  expiration  of  the 
service  - —  or  later,  then  clearly  the  left-hand  entry  records  an 
expense  item,  and  the  account  affected  is  an  expense  account. 

In  accounting  practice  the  accounts  designated  in  this  chapter 
as  current  asset  accounts  are  often  called  expense  accounts.  This 
is  no  very  serious  error  if  it  is  recognized  that  all  the  items  in- 
volved in  such  accounts  are  logically  assets  as  purchased,  and 
give  rise  to  expense  items  only  as  consumed.  As  to  whether  or 
not  such  a  practice  is  justified  is  largely  a  question  as  to  the  normal 
condition  of  such  accounts  during  operation.  If  the  Fuel  account 
of  the  A.  B.  Co.  at  a  given  moment  of  time,  for  example,  shows 
total  debit  entries  of  $400,  and  an  examination  of  the  coal  bins 
reveals  the  fact  that  of  this  total,  fuel  to  the  amount  of  $350  has 
been  consumed,  then  it  is  evident  that  of  the  $400,  but  $50  rep- 
resents an  asset,  the  balance  being  at  this  moment  an  expense. 
Both  items  belong  logically  in  the  left-hand  column,  but  one  is  a 
positive  asset  figure,  the  other  a  deduction  from  revenue.  If 
this  situation  represents  a  normal  condition,  the  Fuel  account 
may  be  defined  from  the  standpoint  of  coal  consumed  rather  than 
coal  purchased. 

A  distinction,  then,  must  sometimes  be  recognized  between  the 
logical  nature  of  the  items  involved  in  a  business  transaction  and 
the  nature  of  the  accounts  which  are  used  to  record  the  trans- 
action. An  account  may  be  defined  or  classified  in  terms  of  its 
predominating  element,  or,  in  other  words,  from  the  standpoint 
of  the  destination  at  the  end  of  the  accounting  period  of  the 
principal  sum  involved  in  the  account.  Thus  the  purchase  of 
assets  may  be  recorded  in  an  "expense"  account,  because  at  any 
given  moment  a  very  large  proportion  of  the  total  amount  shown 
in  the  account  represents  expense.  Even  in  such  a  case,  however, 
it  is  more  rational  to  conceive  of  the  account  as  a  current  asset 
account,  and  a  debit  entry  as  an  addition  to  an  asset,  when  the 
purpose  of  the  classification  is  an  explanation  of  the  structure  of 
a  system  of  accounts  and  the  logical  rules  for  making  debit  and 
credit  entries. 

In  a  lesser  degree  the  accounts  which  represent  the  more  per- 
manent assets  of  an  enterprise  present  the  same  difficulties  of 


52  PRINCIPLES  OF  ACCOUNTING 

classification.  The  Building  account,  for  example,  may  show  at 
a  particular  moment  a  debit  balance  of  $70,000 ;  but  if  an  ap- 
praisal of  the  building  reveals  the  fact  that  the  present  value  is 
but  $69,000,  the  account  at  the  moment  of  appraisal  does  not 
represent  an  asset  alone.  An  element  of  expense  is  involved. 
And,  since  the  depreciation  of  the  building  occurs  continuously, 
it  is  not  feasible  to  represent  this  fact  continuously  in  the  ac- 
counts. Hence,  due  to  the  impossibility  of  subtracting  all  ex- 
pirations from  the  asset  accounts  as  they  occur,  nearly  all  asset 
accounts,  in  practice,  fail  to  represent  continuously  a  single  class 
of  facts.  Just  as  the  Fuel  account  at  a  particular  moment  of 
time  may  represent  coal  consumed  as  well  as  coal  on  hand,  so 
the  Building  account  may  show,  not  simply  an  asset  item,  but 
an  item  of  expense  as  well. 

Some  accounts  in  practice  become  "mixed"  in  the  sense  that 
more  than  one  element  is  specifically  recorded  in  each  account. 
Thus  the  Merchandise  account  as  sometimes  kept  in  the  retail 
business  is  an  asset,  expense  and  revenue  account  combined. 
The  left-hand  column  is  used  to  record  purchases  of  merchandise 
(the  raw  material  of  the  enterprise) ;  the  right-hand  column 
shows  the  sale  of  the  finished  product  (in  this  case  retailed  mer- 
chandise). That  is,  one  column  represents  an  asset,  and  the 
other  revenue  —  a  gross  addition  to  equities.  As  the  raw  mate- 
rial is  consumed  in  operation  the  asset  expires  and  becomes  an 
expense.  Similarly,  in  some  cases  the  Rent  account  is  used  to 
record  asset,  equity,  expense  and 'revenue  items.  The  practice 
of  listing  several  elements  in  a  single  account  can  be  carried  very 
far ;  even  the  balance  sheet  itself  can  be  conceived  as  an  account 
showing  all  the  assets  and  equities  of  the  business.  As  long  as 
the  items  involved  are  grouped  in  the  proper  columns,  however, 
such  mixed  accounts  can  be  used  without  confusion ;  and  the 
rules  for  making  debit  and  credit  entries  are  the  same  for  all  such 
accounts  as  for  pure  accounts.  The  important  cases  of  such 
involved  accounts  will  be  considered  in  some  detail  in  later  chap- 
ters, particularly  in  connection  with  the  discussion  of  the  closing 
of  accounts. 

The  discussion  has  now  been  carried  far  enough  to  suggest  the 
logical  problems  that  arise  in  classifying  accounts  in  actual  prac- 
tice. In  conclusion  it  should  be  emphasized  that  no  classifica- 


CONSTRUCTION  OF  SUPPLEMENTARY  ACCOUNTS        53 

tions  of  facts  in  any  field  of  knowledge  follow  exact  lines  of 
cleavage.  There  are  always  connecting  links,  grounds  of  dubiety, 
points  at  which  one  class  shades  into  another.  But  these  diffi- 
culties do  not  destroy  the  value  of  classifications.  Classifications 
are  primarily  for  purposes  of  convenience ;  a  particular  grouping 
is  adequate  if  it  satisfactorily  serves  the  purpose  in  hand.  For 
some  purposes  distinctions  may  well  be  observed,  for  others 
similarities.  Controversies  concerning  the  legitimacy  of  this  or 
that  particular  classification  usually  arise  because  one  or  more  of 
the  contending  parties  fail  to  appreciate  the  conflicting  purposes 
involved.  The  importance  of  the  purpose  served  in  any  case, 
however,  determines  the  importance  of  the  classification.  In 
Chapter  II  and  the  present  chapter,  to  repeat,  accounts  have  been 
classified  in  terms  of  the  important  logical  concepts  with  which 
accounting  deals  in  order  to  furnish  a  rational  basis  to  the  inter- 
pretation of  all  possible  business  happenings  for  the  purpose  of 
making  debit  and  credit  entries. 

The  explanation  of  the  nature  of  the  principal  types  of  sup- 
plementary accounts  may  be  conveniently  summarized  by  pre- 
senting the  complete  scheme  of  accounts  for  the  A.  B.  Co.  in  its 
relation  to  the  fundamental  equation,  thus : 

THE  A.  B.  Co.'s  ACCOUNTS  l 
ASSETS  EQUITIES 


ADDITIONS 

SUBTRACTIONS 

SUBTRACTIONS 

ADDITIONS 

Land 

A.  B.  Co. 

$40,000 

$170,000 

Deficit 

Surplus 

1  It  must  be  remembered  that  this  illustration  is  not  intended  as  an  exhaustive 
classification  of  the  accounts  likely  to  be  used  by  any  actual  enterprise ;  it  is  rather 
designed  merely  to  suggest  the  structure  of  the  important  types  of  accounts  required 
by  the  typical  enterprise.  The  illustrative  transactions  given  in  Chapter  II  as 
well  as  in  the  present  chapter,  in  so  far  as  these  transactions  affect  the  accounts 
of  the  A.  B.  Co.,  are  recorded  in  the  proper  columns.  No  net  revenue  amounts 


54 


PRINCIPLES  OF  ACCOUNTING 


THE  A.  B.  Co.'s  ACCOUNTS  (Continued) 
ASSETS  EQUITIES 


ADDITIONS 

SUBTRACTIONS 

SUBTRACTIONS 

ADDITIONS 

Building 

Mortgages 

$70,000 
Equip 

Allowance  for 
Depreciation 
of  Buildings 

Notes  P 

$35,000 
5,000 

lyable 

$600 
ment 

$20,000 
4,000 

$1,000 

5,000 

$20,000 
5,000 
2,000 

Mate 

rials 

Re 

venue 

$80,000 
600 

$1,500 

Expense 

$    10 

5 

600 

Ca 

tsh 

NetR 

avenue 

$15,000 
5,000 
1,500 

$   600 
1,000 
2,000 

00 

Interest 

$1,050 

5 
15° 
1,050 
3,000 

A.  B.  Co. 

,  Current 

$3,000 

were  assumed ;    hence  there  are  no  credit  entries  in  the  Net  Revenue  account 
although  distributions  of  net  revenue  are  shown. 


CONSTRUCTION   OF   SUPPLEMENTARY  ACCOUNTS        55 

THE  A.  B.  Co.'s  ACCOUNTS  (Continued} 
ASSETS  EQUITIES 


ADDITIONS 

SUBTRACTIONS 

SUBTRACTIONS                        ADDITIONS 

Supplies 

Fi 

iel 

$60 
Insui 

Sio 
ance 

Miscel 

aneous 

$5 

$s 

IV 

THE  ANALYSIS  AND  RECORDING  OF  TRANSACTIONS 

IN  Chapters  II  and  III  the  general  principles  underlying  the 
structure  of  a  system  of  double-entry  accounts  were  explained, 
and  the  effect  of  the  important  types  of  transactions  upon  the 
individual  accounts  and  the  fundamental  equation  was  shown. 
In  this  exposition,  however,  little  reference  was  made  to  either 
the  details  or  general  features  of  bookkeeping  procedure.  It  is 
the  purpose  of  the  present  chapter  to  describe  briefly  the  more 
significant  forms  of  "books"  which  are  used  in  double-entry 
bookkeeping,  and  to  explain  —  with  reference  to  these  books  — 
the  main  characteristics  of  the  technical  process  of  analyzing 
and  recording  accounting  transactions. 

THE  BOOKS  OF  RECORD  AND  ACCOUNT 

As  a  preliminary  to  a  description  of  the  principal  books  of 
record  and  account  some  further  explanation  of  the  term  trans- 
action should  be  made.  Any  happening  which  affects  an  asset 
or  an  equity  item  (or  some  phase  of  an  asset  or  equity),  or,  in 
other  words,  any  situation  which  gives  rise  to  entries  in  the  ac- 
counts of  an  enterprise,  constitutes  an  accounting  transaction.1 
The  recording  of  transactions  representing  actual  purchase  and 
sale  exchanges  and  the  like  usually  constitutes  the  main  part  of 
the  bookkeeper's  routine  work ;  and  the  forms  and  records  em- 
ployed in  practice  are  specially  constructed  to  facilitate  the 
process  of  analyzing  and  recording  " business"  transactions. 
Nevertheless  it  should  be  remembered  that  changes  in  the  assets 

1  Thus,  "closing"  and  adjusting  entries  made  at  the  end  of  an  accounting  period 
(see  Chapter  VIII),  and  transfer  entries  such  as  those  covering  the  appropriations 
of  the  directors  of  an  incorporated  enterprise,  can  be  said  to  represent  transactions. 

56 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS         57 

and  equities  of  an  enterprise  which  arise  because  of  the  condi- 
tions of  operation  itself  must  also  be  recorded  in  the  accounts ; 
the  consumption  of  coal  must  be  taken  into  consideration  as  well 
as  the  purchase  of  coal.1  But,  as  was  noted  in  the  preceding  chap- 
ter, such  occurrences  are  usually  recorded  only  at  intervals  — 
usually  at  the  time  of  closing  the  accounts.  For  the  purpose  of 
describing  bookkeeping  forms  and  procedure  it  will  therefore  be 
convenient,  at  this  stage,  to  depend  for  illustrative  transactions 
largely  upon  actual  business  happenings. 

As  soon  as  a  transaction  is  recognized  as  taking  place  an  in- 
formal record,  or  memorandum,  of  the  occurrence  is  usually 
made.  In  many  cases  some  document  or  form  —  such  as  a  bill, 
check  or  receipt  —  is  made  out  in  connection  with  the  transaction. 
Such  documents,  collected  in  files,  may  be  thought  of  as  con- 
stituting —  in  the  absence  of  a  formal  book  —  the  book  of  origi- 
nal record.  Or  the  original  narrative  of  the  various  happenings 
may  be  jotted  down  in  a  bound  or  loose-leaf  book ;  in  which  case 
such  a  book  can  be  considered  as  representing  the  first  formal 
record.  The  name  daybook  is  often  applied  to  the  original  record, 
particularly  if  a  bound  volume  is  used  for  this  purpose. 

A  daybook,  in  its  simplest  form,  contains  merely  a  rough  narra- 
tive of  events  —  often  written  in  pencil  —  with  no  specific  ref- 
erence to  accounts  or  to  debit  and  credit  entries.  In  such  a  case 
a  section  of  a  daybook  page  would  appear  somewhat  as  follows  : 

January  2 

Bought  for  cash  10  tons  soft  coal  from  Keck  &  Son  @  $6.  Amount, 
$60.  For  immediate  delivery. 

Hardware  supplies  —  as  per  itemized  bill  of  this  date — were  received 
from  the  Essex  Mfg.  Co.  Total  amount,  $600.  A  check  for  this  amount 
was  made  out  and  mailed. 

3 

Borrowed  $5,000  from  the  First  National  Bank  on  our  6o-day  note  at 
6  %.  This  amount  was  deposited  to  the  credit  of  our  checking  account. 

1  Strictly  speaking,  transactions  which  occur  in  time,  such  as  the  expiration  of  a 
fixed  asset  due  to  deterioration  and  other  factors,  are  infinite  in  number.  Since 
it  is  impracticable  and  even  impossible  to  make  a  record  of  these  transactions  as 
they  occur,  transactions  as  recognized  in  the  accounts  can  be  conceived  as  including, 
in  many  cases,  innumerable  subsidiary  happenings. 


58  PRINCIPLES  OF  ACCOUNTING 

It  is  evident  that  the  details  of  each  transaction  as  recorded  in 
such  a  book  can  be  made  as  exhaustive  or  as  meagre  as  may  be 
desired  in  any  case. 

Accounting  analysis  and  record  proper,  however,  do  not  begin 
with  the  daybook  as  it  has  just  been  described.  In  the  double- 
entry  system  the  two  books  of  fundamental  importance  used  in 
recording  business  transactions  are  the  journal  and  the  ledger. 
A  daybook  and  many  other  supplementary  forms  and  auxiliary 
records  may  be  necessary  —  particularly  in  the  case  of  an  enter- 
prise with  a  complex  organization  and  a  long  and  involved  pro- 
ductive process ;  but  in  any  case  the  fundamental  books  of  the 
double-entry  system  are  the  two  just  mentioned.  The  account- 
ing analysis  and  recording  of  transactions  can  best  be  described 
in  terms  of  these  books. 

The  first  essential  step  is  the  classification  of  each  transaction 
as  it  occurs  into  debit  and  credit  items.  This  process  of  analysis 
is  commonly  spoken  of  as  "journalizing"  because  of  the  practice 
of  recording  the  debit  and  credit  classification  of  data  first  in  the 
journal.  In  this  sense  the  journal  is  the  book  of  "  original  entry." 
The  journal  may  be  a  bound  volume  with  the  simple  page  form 
shown  in  the  following  section,  or  it  may  be  a  complex  book,  or 
series  of  books  and  forms,  as  will  be  explained  in  Chapter  V.  The 
particular  form  of  the  journal  is  not  an  essential  element  in  its 
definition ;  the  journal  is  the  book,  form,  or  forms  in  which  are 
first  recorded  the  debit  and  credit  items  involved  in  the  trans- 
actions that  occur.  Where  the  daybook,  so  called,  is  used  to 
designate  debit  and  credit  entries,  it  virtually  becomes  a  journal. 

Further,  the  debit  and  credit  items,  once  ascertained,  must  be 
listed  in  compact  form  in  the  left-hand  and  right-hand  columns 
of  the  proper  accounts.  The  ledger  is  the  book  of  the  accounts. 
The  simple  form  of  the  ledger  is  also  the  bound  volume,  but  other 
forms  are  possible.  The  ledger  also  may  be  a  series  of  books  or 
forms  as  will  be  shown  in  the  following  chapter. 

The  use  of  two  fundamental  books  in  recording  business  trans- 
actions is  somewhat  arbitrary.  Each  transaction  must  be  ana- 
lyzed into  debit  and  credit  items  and  these  items  must  be  entered 
in  accounts,  as  explained  in  Chapter  II,  if  the  double-entry  de- 
vice is  to  be  employed.  The  use  of  two  books  in  this  process 
instead  of  one,  however,  is  largely  a  matter  of  clerical  conven- 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS         59 

ience,  and  there  is  some  tendency  in  bookkeeping  technique  to 
reduce  the  financial  books  proper  to  simply  the  books  of  account. 
Yet  however  technique  may  develop  the  essentials  of  the  process 
must  remain  the  same:  (i)  each  transaction  must  be  classified 
into  debit  and  credit  items;  (2)  these  debits  and  credits  must 
be  actually  carried  to  the  accounts  affected.  If  but  one  book  is 
used  this  book  constitutes  both  journal  and  ledger.  Throughout 
the  text  the  separation  of  the  two  seeps  will  be  maintained,  and 
the  device  of  the  simple  journal  entry  will  be  used  as  a  representa- 
tion of  the  process  of  debit  and  credit  analysis.  A  more  detailed 
description  of  these  important  books  will  now  be  given. 

THE   JOURNAL 

The  journal,  as  stated  above,  is  the  book  of  original  entry. 
As  ordinarily  used  it  can  be  said  to  have  two  functions  :  first,  it 
furnishes  a  record  of  the  classification  of  transactions  into  debit 
and  credit  items ;  second,  it  gives  brief  details  in  connection  with 
each  transaction.  No  other  formal  book  for  recording  the  origi- 
nal narrative  is  then  necessary,  although  the  journal  record  is 
usually  transcribed  at  regular  intervals  from  rough  memoranda, 
underlying  papers,  or  a  daybook.  The  simple  journal  is  a  bound 
volume  with  numbered  pages.  A  section  of  a  page  from  such  a 
journal  would  appear  somewhat  as  the  table  at  top  of  page  60. 

The  left  of  the  two  columns  at  the  right  of  the  page  is  the  col- 
umn in  which  are  listed  the  debit  amounts ;  the  right-hand  col- 
umn is  for  credit  items.  The  name  of  each  account  is  given  a 
single  line ;  in  this  way  the  details  or  explanations  are  not  likely 
to  be  confused  with  the  account  titles  in  the  process  of  trans- 
ferring the  amounts  to  the  ledger.  The  debit  accounts  are  first 
stated  in  each  case.  This  is  the  conventional  arrangement. 
The  name  of  the  account  which  is  to  be  credited  is  indented  to 
the  right.  Where  several  debit  or  credit  accounts  are  involved 
in  a  single  transaction  it  is  desirable  to  follow  the  conventional 
form,  listing  first  all  debit  accounts  —  a  separate  line  for  each 
account  —  and  then  all  credit  accounts.  In  the  column  at  the 
left  of  the  page  are  given  the  ledger  page  numbers  of  the  various 
accounts  involved.  These  ledger  page  numbers  should  always 
be  given  in  the  journal  to  facilitate  the  comparison  of  the  two 


6o 


PRINCIPLES  OF  ACCOUNTING 


L.  F. 

28 
7 


7 
32 


ii 

7 
32 


15 
7 


46 


January  2 
Materials 
Cash 

Bought  for  cash  from  the  Essex  Mfg.  Co.  materials 
as  per  itemized  bill  of  this  date. 

Cash 

Notes  Payable 

Borrowed  $5,000  from  the  First  National  Bank  on 
our  6o-day  note  at  6%. 


Equipment 
Cash 

Notes  Payable 
Additional  equipment  was  purchased  from  the  Bur- 
gan  Supply  Co.for  cash  and  note. 

Fuel 

Cash 
Bought  for  cash  10  tons  soft  coal  @  $  6. 

Cash 

Revenue 

Finished  goods  sold  for  cash  to  H.  J.  Harvey  as  per 
invoice  of  this  date. 


$    600 


5,000 


4,000. 


60 


1,000 


$    600 


5,000 


2,000 
2,000 


60 


1,000 


books  whenever  need  for  such  comparison  arises ;  and  these 
numbers  also  serve  as  a  check  on  the  accuracy  of  the  bookkeeper's 
work  in  transferring  items  from  the  journal  to  the  ledger. 

The  process  of  entering  a  debit  item  in  the  journal  is  usually 
called  "charging"  :  to  debit  an  account  is  to  charge  an  account. 
Entering  credit  or  right-hand  items  is  called  " crediting."  In 
making  journal  entries  the  words  to  or  by  are  often  used,  thus : 


Fuel- 


$60 


to  Cash 


$60 


The  use  of  the  preposition  serves  no  purpose  except  to  indicate 
further  which  item  is  a  debit  and  which  a  credit.  Indeed  such 
terms  are  likely  to  be  more  confusing  than  helpful.  There  is  no 
time  or  other  sequence  between  the  debit  and  credit  items  in- 


ANALYSIS  AND   RECORDING   OF  TRANSACTIONS         6l 

volved  in  a  transaction.  The  conventional  method  of  indenting 
the  credit  accounts  to  the  right,  as  shown  above,  suggests  the 
spatial  arrangement  of  debits  and  credits  and  is  probably  the 
most  satisfactory  of  all  devices.  If  this  is  done  there  is  no  need 
of  further  explanation. 

The  importance  of  the  journal  when  considered  as  representing 
the  primary  debit  and  credit  analysis  of  the  transactions  is  evi- 
dent. The  structure  of  the  double-entry  system  depends  upon  a 
debit  and  credit  classification  of  items.  Such  a  classification  is 
the  first  essential  step  in  interpreting  accounting  data,  and  the 
use  of  parallel-column  accounts,  as  shown  in  Chapter  II,  is  im- 
possible without  this  analysis.  Further,  an  orderly  statement 
of  the  important  details  connected  with  each  transaction  is  very 
necessary  for  future  reference  in  case  of  misunderstandings, 
audits,  legal  complications  or  other  contingencies.  For  this 
reason  it  is  desirable  that  the  journal  narrative  give  a  rather  full 
explanation  of  each  transaction,  instead  of  a  very  much  abbre- 
viated statement. 

As  stated  above,  many  of  the  original  details  may  be  recorded 
in  other  books  and  forms  than  the  journal  proper.  Notes  pay- 
able and  notes  receivable  registers  may  be  kept,  for  example,  in 
which  are  recorded  the  details  in  connection  with  these  types  of 
commercial  paper.  Various  other  kinds  of  memoranda  are  used 
in  keeping  the  record  of  original  data ;  and,  of  course,  original 
documents  such  as  receipts,  vouchers,  bills  of  lading,  etc.,  are  to  a 
great  extent  preserved  and  kept  on  file  to  supplement  the  books 
proper.  From  the  standpoint  of  authenticity  in  legal  and  other 
disputes  these  underlying  papers  naturally  carry  more  weight 
than  the  journal.  As  far  as  the  formal  books  are  concerned, 
however,  the  journal,  as  stated  above,  is  the  book  of  original 
entry. 

The  journal  itself  is  often  subdivided  into  a  number  of  special 
books.  The  cash  book,  the  purchase  book  and  the  sales  book  are 
the  common  examples  of  such  special  journals.  The  names  of 
these  books  suggest  their  nature.  The  use  of  these  additional 
books  is  of  advantage  in  economizing  clerical  effort;  and  they 
also  serve  to  isolate  in  the  accounts  each  department  or  phase  of 
the  business.  These  and  other  modifications  of  the  simple 
journal  will  be  described  in  Chapter  V. 


62 


PRINCIPLES  OF  ACCOUNTING 


THE    LEDGER 

The  ledger,  as  explained  above,  is  the  book  of  final  account. 
It  is  the  book  of  the  accounts  proper,  representing  the  organiza- 
tion of  the  debits  and  credits  of  the  journal  into  compact  form 
and  allocated  to  the  various  accounts  affected  by  the  transactions. 
The  difference  between  the  journal  and  ledger  in  regard  to  the 
organization  of  data  may  be  expressed  in  this  way :  in  the  jour- 
nal the  unit  is  the  transaction;  in  the  ledger  the  unit  is  the  ac- 
count. 

The  simple  form  of  the  ledger  is  also  a  bound  volume,  although 
innumerable  variations  are  possible.  Each  account  may  be 
given  a  single  page,  or  more  or  less  than  a  page  according  as  it  is 
expected  that  there  will  be  a  large  or  small  number  of  trans- 
actions affecting  the  account.  The  accounts  are  commonly 
arranged  alphabetically  rather  than  in  logical  groups,  because 
this  arrangement  can  be  more  readily  used  for  reference  purposes. 

The  conventional  ledger  account  has,  roughly,  the  following 
form : 


CASH 


1918 

K)  1  8 

Jan.  2 

Ji 

$15,000 

Jan.  2 

J3 

$  600 

4 

J4 

500 

3 

J4 

1,000 

5 

J5 

1,25° 

3 

J4 

2,000 

4 

J4 

60 

5 

J5 

5 

5 

J5 

15° 

Usually,  as  in  the  above  case,  the  ledger  contains  simply 
the  heading  or  name  of  the  account,  the  date  of  each  entry,  the 
journal  page  on  which  may  be  found  the  original  entry,  and  the 
amount.  Sometimes  the  name  of  the  account  that  contains 
the  concurrent  opposite  entry  is  written  in.  There  are  not  many 
cases  in  which  this  is  necessary,  for  if  the  journal  page  is  given 
the  details  of  the  transaction  giving  rise  to  a  particular  ledger 


ANALYSIS  AND   RECORDING   OF  TRANSACTIONS        63 

entry  can  be  readily  ascertained.  It  is  the  particular  function 
of  the  ledger  to  summarize  the  transactions  in  connection  with 
each  account  so  that  conclusions  concerning  the  status  of  each 
account  may  be  drawn.  Or,  in  other  words,  it  is  the  function 
of  the  ledger  to  show  under  each  account  heading  all  plus  and 
minus  items  —  opposite  tendencies  — •  pertaining  to  that  account, 
so  that  a  balance  can  readily  be  taken. 

The  ledger,  like  the  journal,  may  be  divided  into  a  number  of 
special  books,  and  the  extent  to  which  it  is  expedient  to  carry 
this  subdivision  depends  upon  the  nature  of  the  enterprise  in  any 
case.  The  most  common  examples  of  such  specialized  ledgers 
are :  the  expense  ledger,  often  containing  current  asset  accounts 
as  well  as  pure  expense  accounts ;  the  creditors'  ledger,  contain- 
ing the  " accounts  payable"  (a  separate  account  for  each  person 
or  firm);  and  the  customers'  ledger,  embracing  the  "accounts 
receivable"  (a  separate  account  with  each  individual  or  firm). 
The  cash  book,  which,  as  stated  in  the  preceding  section,  is  pri- 
marily a  journal  of  transactions  involving  cash,  may  also  be  used 
as  a  ledger  containing  the  single  account,  Cash.  The  general 
ledger  includes  all  the  accounts  not  contained  in  the  special 
ledgers  and  controlling  or  summary  accounts  of  the  special  ledgers 
as  well. 

The  accounts  payable  of  the  creditors'  ledger  represent  current 
obligations  of  the  firm  —  usually  obligations  incurred  through 
the  purchase  of  raw  materials,  merchandise  and  other  supplies 
on  credit.  Because  credit  purchases  are  the  usual  thing  in  many 
lines  of  business,  the  number  of  transactions  to  be  recorded  in 
these  accounts  is  often  very  large.  Such  accounts,  evidently, 
represent  current  equities  in  the  enterprise.  The  time  allowed 
on  credit  purchases  is  usually  either  thirty  or  sixty  days.  The 
goods  so  purchased  represent  assets  as  received,  and  should  be 
recorded  as  such.  Since  payment  for  these  assets  is  postponed, 
current  equities  for  the  same  amounts  (represented  usually  by 
the  names  of  the  firms  from  whom  the  purchases  are  made)  must 
also  appear  in  the  records. 

Similarly,  the  accounts  receivable  of  the  customers'  ledger 
represent  current  claims  which  the  enterprise  has  against  other 
firms  and  individuals  —  claims  usually  arising  from  the  sale  of 
finished  product  on  credit.  Illustrative  transactions  affecting 


64  PRINCIPLES  OF  ACCOUNTING 

these  accounts  and  the  accounts  payable  as  well  will  be  given  in 
the  following  section. 

The  possibility  of  using  controlling  accounts  for  the  special 
ledgers  was  mentioned  above.  A  controlling  account  is  of  ad- 
vantage in  cases  where  detailed  information  is  necessary  for  one 
purpose  and  summary  information  for  another.  For  example, 
the  sales  manager  may  desire  to  determine  at  a  glance  the  amount 
of  outstanding  customers'  accounts.  Hence  the  general  ledger 
should  include  an  Accounts  Receivable,  which  is  a  controlling  or 
summary  account  of  the  customers'  ledger.  Similarly,  there 
should  be  a  controlling  account,  Accounts  Payable,  for  the  credi- 
tors' ledger.  The  use  of  controlling  accounts  makes  it  possible 
to  have  in  the  general  ledger  a  complete  representation  of  the 
business.  Conclusions  concerning  the  status  of  the  enterprise 
at  any  time  can  then  be  drawn  from  one  book.  The  controlling 
account  device  may  be  carried  very  far  in  practice.  In  some 
cases  each  general  ledger  account  "controls"  several  subsidiary 
accounts. 

The  nature  and  use  of  the  special  ledgers  will  be  further  ex- 
plained in  a  later  chapter.  The  clerical  advantage  of  such  books, 
and  of  controlling  accounts,  depends  largely  upon  the  device  of 
the  special-column  journal,  which  will  be  described  in  some  detail 
in  Chapter  V. 

JOURNALIZING 

As  has  been  stated,  it  is  one  function  of  the  journal  to  present  a 
classification  of  transactions  in  debit  and  credit,  or  left-hand  and 
right-hand,  entries.  Thus  it  is  apparent  that  journalizing  in- 
volves more  than  the  mere  recording  of  facts.  The  first,  and  a 
very  important,  step  in  interpretation  is  taken  in  the  process  of 
grouping  debits  and  credits.  Whenever  both  balance  sheet 
classes  are  involved  this  classification  makes  the  fundamental 
distinction  between  asset  and  equity  items.  If  the  bookkeeper 
is  handed  a  memorandum  on  which  are  given  the  details  of  the 
transaction  and  the  names  of  the  accounts  involved,  and  on 
which  it  is  already  indicated  for  him  which  entries  are  debits 
and  which  are  credits,  then  journalizing  from  that  point  is  mere 
copying  or  recording,  for  the  important  process  has  already  been 
completed. 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS        65 

The  fundamentals  of  journalizing  have  already  been  brought 
out  in  explaining  the  structure  of  the  accounts  and  the  under- 
lying principles  for  making  debit  and  credit  entries.  This  clas- 
sifying of  transactions  into  debit  and  credit  accounts  is  of  primary 
importance,  and  is  a  matter  which  presents  considerable  diffi- 
culty to  the  beginner.  The  classification  of  transactions  given 
in  Chapter  II  will  therefore  be  repeated,  and  some  additional  il- 
lustrative cases  will  be  analyzed.  Although  the  second  function 
of  the  journal  mentioned  above  —  the  showing  of  the  impor- 
tant details  in  connection  with  each  transaction  —  is  of  impor- 
tance, it  presents  no  difficulty  and  will  be  ignored  in  the  following 
discussion  of  journal  entries. 

a.  Transactions  occur  which  involve  the  exchange  of  valuable 
commodities  or  services  for  other  commodities  or  services  of  equal 
value.  In  such  cases  a  debit  entry  always  means  an  addition  to 
an  asset,  and  a  credit  entry  always  indicates  a  subtraction  from 
an  asset. 

Examples 

1.  The  A.  B.  Co.  loans  $500  to  A  (one  of  the  proprietors)  in 
exchange  for  his  sixty-day  note  at  six  per  cent.     What  would  be 
the  journal  entries  in  this  case?     One  asset,  cash,  has  been  de- 
creased to  the  amount  of  $500,  and  another  asset,  notes  receivable 
(a  right  against  A  in  this  case),  has  been  increased  a  like  amount. 
The  journal  entries  would  therefore  be : 

Notes  Receivable $500 

Cash $500 

2.  Materials  to  the  amount  of  $2,000  are  bought  for  cash  from 
Rankin  &  Co.     This  means  a  subtraction  from  cash  of  $2,000  and 
an  addition  to  another  asset,  materials,  of  the  same  amount. 
The  transaction  would  accordingly  be  journalized  by  a  debit, 
or  charge,  to  Materials  and  a  credit  to  Cash,  thus : 

Materials $2,000 

Cash $2,000 

3.  The  equipment  is  insured  for  $24,000  for  three  years.     The 
premium  of  $240  is  paid  in  cash.     This  transaction  represents 
the  purchase  of  a  service  for  cash.     Protection  from  certain  pos- 


66  PRINCIPLES  OF  ACCOUNTING 

sible  losses  is  secured  for  a  period  of  three  years,  and  payment 
is  made  in  advance.  The  insurance  premium  in  this  case  rep- 
resents an  asset  charge ;  a  right  —  covering  a  period  of  three 
years  —  is  secured.  As  this  right  expires,  it  will  constitute  ex- 
pense. The  situation  is  analogous  to  the  purchase  of  a  machine 
for  $240,  which,  it  is  expected,  will  last  three  years.  At  the 
moment  of  purchase  the  entire  amount  is  an  asset  charge ;  as 
the  machine  depreciates  the  amount  should  be  transferred  to  an 
expense  account. 

This  transaction  would  therefore  be  journalized  by  a  left-hand 
or  debit  entry  to  Insurance  and  a  right-hand  or  credit  entry  to 
Cash: 

Insurance $240 

Cash $240 

Many  similar  transactions  involving  the  purchase  of  services 
and  rights  covering  a  considerable  period  are  met  with  in  business 
practice.  All  such  transactions  should  be  analyzed  in  the  same 
manner  as  this  case. 

4.  The  A.   B.   Co.   agrees  to  purchase  delivery  equipment 
amounting  to  $300  from  Rankin  &  Co.  provided  the  latter  firm 
will  accept  in  payment  a  return  of  unused  raw  material  amount- 
ing to  $300  (cost  price).     This  agreement  is  carried  out.     The 
journal  entries  would  be : 

Equipment $300 

Materials $300 

Such  barter  transactions  —  particularly  those  which  do  not  in- 
volve either  expense  or  revenue  items  —  are  very  exceptional 
under  modern  business  conditions. 

5.  It  is  estimated  that  raw  material  to  the  amount  of  $700  has 
been  taken  from  the  store  room  and  is  now  in  the  factory  in  the 
form  of  semi-finished  goods.     This  situation  may  be  recognized 
in  the  accounts  by  the  following  entries  : 

Goods  in  Process $700 

Materials $700 

Such  transactions  are  of  common  occurrence  in  the  accounts  of 
manufacturing  enterprises.  Three  accounts  —  or  groups  of 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS        67 

accounts  —  corresponding  to  the  important  stages  in  the  manu- 
facturing process  are  usually  adopted.  These  accounts  are : 
Materials ;  Goods  in  Process ;  Finished  Goods.  At  intervals  the 
changes  in  form  which  some  of  the  assets  are  undergoing  are 
recorded  in  these  accounts.  All  such  transactions  may  be  con- 
ceived as  internal  transpositions  of  assets ;  in  each  case  there 
is  no  connection  with  any  outside  firm  or  individual. 

6.  The  Y.  Co.  settles  an  open  account  for  $1,000  in  favor  of 
the  A.  B.  Co.  with  its  sixty-day  note  at  six  per  cent.     This  trans- 
action involves  —  on  the  books  of  the  A.  B.  Co.  —  a  subtraction 
from  accounts  receivable  and  an  equal  addition  to  notes  receiv- 
able.    The  journal  entries  would  therefore  be : 

Notes  Receivable $1,000 

Accounts  Receivable $1,000 

(The  Y.  Co.) 

This  accounting  procedure  recognizes  the  legal  and  commercial 
distinction  between  open  book  accounts  and  promissory  notes. 
The  accounts  now  show  that  the  Y.  Co.  no  longer  owes  the  A.  B. 
Co.  on  the  basis  of  a  bill  of  goods,  but  on  a  promissory  note ;  the 
open  account  is  cancelled,  and  is  replaced  by  a  new  asset  —  a  new 
right  against  the  Y.  Co.  Such  transactions  are  of  quite  common 
occurrence. 

7.  Another  illustration  of  the  transposition  of  assets  is  found 
in  the  case  where  an  enterprise  sets  aside  cash,  or  other  liquid 
assets,  as  a  fund  to  be  used  for  some  special  purpose.     The  term 
"sinking  fund"  is  often  applied  in  this  connection.     The  A.  B. 
Co.,  for  example,  decides  to  deposit  $1,000  each  year  with  a  trus- 
tee, in  order  to  accumulate  a  fund  of  liquid  assets  sufficient  to 
meet  a  certain  mortgage  at  maturity.     The  journal  entries  cover- 
ing such  a  deposit  would  appear  as  follows  : 

Sinking  Fund  Assets $1,000 

Cash $1,000 

The  intricacies  of  the  sinking  fund  cannot  be  discussed  at  this 
point,  but  it  should  be  clear  to  the  student  that  such  a  transaction 
as  this  represents  an  exchange  of  assets. 

All  transactions  which  involve  simply  asset  exchanges  are 
entered  in  the  journal  according  to  the  same  principles  of  analysis 


68  PRINCIPLES  OF  ACCOUNTING 

that  govern  the  treatment  of  the  above  cases.  Such  transactions 
affect  only  one  member  of  the  fundamental  equation,  as  was 
pointed  out  in  Chapter  II.  Hence  the  problem  of  interpretation 
involved  in  making  journal  entries  for  these  cases  is  simply  that 
of  distinguishing  between  additions  to  and  subtractions  from 
assets,  and  selecting  the  accounts  affected.  It  is  worth  noticing 
that  the  Cash  account  is  involved  in  the  majority  of  such  cases. 
Cash,  being  the  only  legal  tender,  is  the  only  asset  possessed  by  a 
given  enterprise  which  it  can  readily  exchange  for  other  assets. 

b.  Transactions  frequently  occur  which  represent  an  increase 
or  decrease  in  assets  and  an  equal  increase  or  decrease  in  equities. 
The  complete  rule  for  making  debit  and  credit  entries  is  necessary 
to  cover  all  such  cases  :  debit  indicates  an  addition  to  assets  or  a 
subtraction  from  equities ;  credit  indicates  a  subtraction  from 
assets  or  an  addition  to  equities.  Further,  it  must  be  remem- 
bered that  an  addition  to  equities  may  be  a  net  addition  or  a 
gross  addition  (revenue),  and  that  a  subtraction  from  equities 
may  be  made  directly  through  some  equity  account,  or  as  a  sub- 
traction from  revenue  —  an  expense  charge. 

Examples 

1.  Notesof  the  A.  B.  Co.  are  retired  with  cash,  $5,000.     In  this 
case  an  equity  is  reduced  $5,000  and  there  is  a  corresponding  re- 
duction in  an  asset,  cash.     The  transaction  would  be  journalized 
by  a  debit  to  Notes  Payable  and  a  credit  to  Cash,  thus  : 

Notes  Payable $5,000 

Cash $5,000 

2.  Materials  are  bought  on  account  from  Rankin  &  Co.  to 
the  amount  of  $1,200.     An  asset,  materials,  has  been  increased, 
and  a  liability,  accounts  payable,  has  been  increased  an  equal 
amount.     The  entries  would  then  be : 

Materials $1,200 

Accounts  Payable $1,200 

(Rankin  &  Co.) 

If  these  materials  had  been  purchased  with  a  note,  the  only  dif- 
ference in  the  entries  would  be  that  another  equity  account, 
Notes  Payable,  would  be  credited  instead  of  Accounts  Payable. 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS        69 

3.  It  is  decided  that  $150  represents  a  month's  accrued  de- 
preciation on  the  A.  B.  Co.'s  building,  and  the  bookkeeper  is 
asked  to  recognize  this  fact  in  the  accounts.     This  transaction 
involves  a  subtraction  from  an  asset,  building,  of  $150,  and  an 
equal  subtraction  from  revenue  through  the  Expense  account. 
The  journal  entries  would  appear  as  follows : 

Expense $150 

Building1 $150 

4.  The  A.  B.  Co.  needs  additional  capital;   and  a  new  mort- 
gage on  real  estate  is  issued,  $5,000.     This  transaction  means  an 
addition  to  an  asset,  cash,  and  an  equal  addition  to  an  equity, 
mortgages.     Accordingly  the  entries  would  be : 

Cash $5,000 

Mortgages       $5,000 

5.  The  month's  consumption  of  coal  is  $100.     This  transaction 
would  be  recorded  by  a  credit  to  Fuel  (indicating  the  subtraction 
from  an  asset)  and  an  equal  debit  to  Expense  (indicating  the 
subtraction  from  revenue),  thus : 

Expense $100 

Fuel $100 

All  transactions  involving  expirations  of  assets  in  operation  are 
journalized  according  to  this  analysis. 

6.  The  weekly  payroll  is  met  with  cash,  $500.     The  journal 
entries  would  be  as  follows : 

Expense $500 

Cash $500 

This  transaction  illustrates  the  use  of  a  direct  charge  to  Expense 
for  services  purchased  instead  of  to  an  asset  account.  If  a  special 
expense  account,  Labor,  were  used,  the  entries  would  be  : 

Labor $500 

Cash $500 

1  The  valuation  account,  Allowance  for  Depreciation  of  Buildings,  would  often 
be  credited  instead  of  Building. 


70  PRINCIPLES  OF  ACCOUNTING 

7.  The  following  bills  are  received  :  light,  $12  ;  telephone,  $8 ; 
fre-ght  and  cartage,  $50.     Checks  are  drawn  and  mailed  for  the 
amount  of  these  bills.     This  transaction  would  be  journalized  : 

Expense $70 

Cash $70 

A  special  expense  account  might  also  be  used  for  each  of  these 
items.  Nearly  all  small  amounts  of  this  kind  are  charged  di- 
rectly to  an  expense  account  even  if  payment  is  made  before  the 
receipt  of  the  commodity  or  service  involved.  Such  items  are 
transitory  in  character  and  are  usually  viewed  from  the  stand- 
point of  their  destination  in  the  accounts. 

8.  Finished  goods  are  sold  for  cash,  $500.     An  asset,  cash,  is 
increased,  and  revenue  is  increased  a  like  amount.     The  trans- 
action would  therefore  be  journalized  as  follows  : 

Cash $500 

Revenue $500 

In  practice  the  Revenue  account  is  often  called  the  "Sales"  ac- 
count. 

9.  The  A.  B.  Co.  rents  a  portion  of  its  building  for  $50  per 
month.     A   month's   rent   is   received.     This   transaction   also 
represents  an  addition  to  an  asset  and  an  equal  addition  to  rev- 
enue.    In  this  case  the  revenue  arises  in  connection  with  the 
performance  of  an  ancillary  service.     The  entries  for  this  trans- 
action would  appear  as  follows : 

Cash $50 

Revenue $50 

For  statistical  purposes  a  special  revenue  account,  Rent,  might 
be  used. 

10.  The  firm  is  credited  with  interest  on  its  bank  balance,  $40. 
This  is  another  revenue  transaction.     Since  the  item  of  revenue 
is  net  in  this  case,  however,  the  Net  Revenue  account  should  be 
credited,  thus: 

Cash '  .      $40 

Net  Revenue    .  $40 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS        71 
Or  a  special  account,  Interest  Received,  may  be  credited,  thus: 


Cash 

Interest  Received 


IT.  The  firm  pays  interest  on  outstanding  mortgages,  $400. 
This  transaction  is  essentially  the  reverse  of  the  preceding  illus- 
tration ;  it  represents  a  subtraction  from  an  asset,  cash,  and 
an  equal  subtraction  from  an  equity,  net  revenue.  The  journal 
entries  would  be : 

Net  Revenue $400 

Cash $400 

Or  a  special  account,  Interest  Paid,  may  be  debited,  thus  : 

Interest  Paid $400 

Cash $400 

12.  The  firm  sells  goods  on  account  to  H.  A.  Wilcox,  $150. 
This  transaction  represents  an  increase  in  an  asset  and  an  equal 
increase  in  revenue.  Accordingly  the  entries  would  be  : 

Accounts  Receivable $150 

(H.  A.   Wilcox) 

Sales $150 

According  to  the  terms  of  the  sale,  it  will  be  assumed,  the  buyer 
is  to  be  allowed  a  two  per  cent  discount  if  the  bill  is  paid  within 
ten  days.  The  bill  is  paid  and  the  discount  is  allowed.  This 
transaction  would  be  journalized  as  follows : 

Cash $147 

Sales  Discounts 3 

Accounts  Receivable $i  50 

(H.  A.  Wilcox) 

This  transaction  illustrates  the  general  practice  of  allowing  cash 
and  trade  discounts,  and  other  rebates  and  allowances,  in  com- 
mercial transactions.  The  usual  bill  of  purchase  or  sale  contains 
alternative  terms  of  settlement.  If  cash  is  paid  within  a  certain 
specified  time  it  is  customary  to  allow  a  discount  on  the  gross 
price.  In  this  case  the  amount  of  the  discount  is  $3.  This 
item  represents  a  subtraction  from  the  amount  credited  to  the 


72  PRINCIPLES  OF  ACCOUNTING 

Sales  account  in  the  preceding  entry.  Sales  Discounts  is  there- 
fore a  valuation  account,  showing  subtractions  from  an  overstated 
revenue.  The  amount  of  the  discount  might  logically  have  been 
charged  directly  to  Sales. 

13.  To  illustrate  transactions  involving  purchase  discounts 
it  might  be  assumed  that  Rankin  &  Co.  offer  a  discount  of  two 
per  cent  on  the  bill  mentioned  in  (2)  above.     If  the  discount  is 
accepted  by  the  buyer  the  entries  when  the  account  is  paid  would 
appear  as  follows : 

Accounts  Payable $1,200 

(Rankin  &  Co.) 

Cash $1,176 

Purchase  Discounts 24 

Purchase  Discounts  is  another  valuation  account  and  the  amount 
shown  by  such  an  account  is  a  deduction  from  the  cost  of  mate- 
rials and  supplies  which  have  been  entered  at  the  gross  rather 
than  the  actual  price.  A  discount  accepted  on  goods  purchased 
and  entered  at  a  gross  price  might  therefore  be  logically  credited 
directly  to  the  asset  account  in  question. 

Valuation  accounts  of  this  kind  are  very  common  in  account- 
ing practice,  and  some  difficult  problems  of  analysis  arise  in  con- 
nection with  such  accounts.1  A  further  discussion  of  transactions 
involving  adjustments  of  costs  and  revenues  will  be  given  in  a 
later  chapter. 

14.  An  actual  loss  or  gain  represents  a  transaction  which  af- 
fects both  members  of  the  fundamental  equation  directly.     An 
officer  of  the  A.  B.  Co.  embezzles  cash  amounting  to  $1,500.    The 
following  entries  would  be  a  recognition  of 'this  occurrence  in 
the  accounts : 

Surplus $1,500 

Cash $1,500 

Since  this  defalcation  represents  a  net  decrease  in  assets  with  no 
compensating  advantages  it  also  constitutes  a  net  subtraction 
from  proprietorship.  If  there  be  no  Surplus  account  in  a  given 
case,  a  charge  should  be  made  to  the  original  proprietorship 
account,  or  to  some  valuation  account  such  as  Deficit. 

1  See  Appendix  A. 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS        73 

The  opposite  of  this  transaction  would  be  an  extraordinary 
gain,  such  as  a  gift.  Transactions  involving  actual  loss  and  gain 
are  not  of  very  common  occurrence  in  the  typical  business  enter- 
prise. 

The  above  cases  are  typical  of  the  situations  which  give  rise 
to  entries  affecting  both  the  asset  and  equity  classes.  In  inter- 
preting transactions  of  this  type  it  should  be  constantly  kept  in 
mind  that  the  expense  and  revenue  and  other  supplementary 
accounts  involved  can  only  be  understood  in  view  of  their  rela- 
tion to  the  balance  sheet  accounts.  The  Revenue  account  is 
credited  with  all  sales  of  product,  for  revenue  represents  gross 
additions  to  the  balance  sheet  equities.  Expense  accounts  are 
charged  with  all  commodities  and  services  consumed  because 
these  expirations  constitute  subtractions  from  revenue. 

c.  Transactions  may  occur  which  affect  only  the  equities  — 
the  right-hand  member  of  the  fundamental  equation.  One 
equity  may  be  increased  and  another  decreased  a  like  amount. 
The  exchange  of  notes  and  accounts  payable  gives  a  simple 
illustration.  The  A.  B.  Co.  gives  its  sixty-day  note  at  six  per 
cent  for  $1,000  to  cover  an  open  account  in  favor  of  Rankin  &  Co. 
of  the  same  amount.  The  entries  would  accordingly  be : 

Accounts  Payable $1,000 

(Rankin  &  Co.) 

Notes  Payable $1,000 

This  transaction  involves  a  subtraction  from  one  equity,  accounts 
payable,  of  $1,000,  and  an  equal  addition  to  another  equity,  notes 
payable.  In  each  case  it  is  Rankin  &  Co.  that  has  the  claim 
against  the  A.  B.  Co.,  but  this  claim  now  is  represented  by  a 
promissory  note  instead  of  by  a  book  account. 

Such  transactions  are  of  quite  common  occurrence  —  par- 
ticularly in  the  case  of  incorporated  enterprises.1  A  large 
number  of  the  transfer  entries  made  in  the  process  of  closing  the 
accounts  fall  under  this  head.  It  will  be  desirable  to  postpone 

1  The  refunding  of  securities ;  the  division  of  surplus  into  a  variety  of  forms 
(such  as  the  declaration  of  dividends) ;  the  exchange  of  securities  for  other  equities 
(e.g.  the  funding  of  a  floating  debt  of  general  creditors'  accounts  into  bonds  or  other 
securities) :  all  these  operations  involve  merely  the  exchange  of  equities,  and  do  not 
affect  the  asset  accounts. 


74  PRINCIPLES  OF  ACCOUNTING 

the  discussion  of  further  illustrations  until  later  chapters,  how- 
ever, since  such  transactions  are  largely  restricted  to  the  period 
of  closing  and  to  the  corporate  form  of  organization. 

d.  A  great  many  business  happenings  represent  combinations 
of  the  above  types  of  transactions. 

Examples 

1.  A  machine  which  cost  $200,  and  has  been  carried  on  the 
books  at  that  figure,  is  sold  for  $150.     This  transaction  involves 
an  addition  to  assets  of  $150,  a  subtraction  from  revenue  of  $50 
and  a  reduction  in  assets  of  $200.     The  entries,  therefore,  would 
be  as  follows : 

Cash $150 

Expense 50 

Equipment $200 

2.  The  firm  buys  supplies  from  Rankin  &  Co.  amounting  to 
$400.     In  making  payment  the  firm  transfers  to  Rankin  &  Co. 
an  account  which  it  holds  against  H.  A.  Wilcox,  $50,  gives  its 
thirty-day  note  at  six  per  cent  for  $100,  and  pays  the  balance  in 
cash.     In  this  transaction  one  asset,  cash,  is  decreased  $250, 
another  asset,  accounts  receivable,  is  reduced  by  $50,  an  equity, 
notes  payable,  is  increased  $100,  and  an  asset,  supplies,  is  re- 
ceived amounting  to  $400.     The  entries  would  be : 

Supplies $400 

Cash 

Notes  Payable 

Accounts  Receivable 

(H.  A.  WUcox) 

Although  such  transactions  may  be  quite  complex  no  new  prin- 
ciples of  analysis  are  required  for  such  cases. 

All  possible  transactions  are  covered  by  the  above  classifica- 
tion. An  application  of  this  analysis  to  other  transactions  will 
be  made  in  succeeding  chapters.  It  should  be  emphasized  again 
that  journalizing  represents  a  highly  important  step  in  interpre- 
tation, for  this  is  the  process  which  classifies  transactions  into 
debit  and  credit  entries. 


ANALYSIS  AND   RECORDING  OF  TRANSACTIONS        75 

POSTING 

The  process  of  transferring  items  from  the  journal  to  the  ledger 
is  known  as  posting.  It  is  purely  a  clerical  matter.  Once  a 
transaction  has  been  journalized  the  debit  and  credit  classifica- 
tion is  made.  Posting,  then,  consists  simply  in  the  allocation  of 
all  debits  as  indicated  by  the  journal  to  the  left-hand  column  of 
the  proper  ledger  accounts  and  all  credits  to  the  right-hand 
column  of  the  proper  accounts. 

For  an  illustration  of  the  process  of  posting  it  will  be  conven- 
ient to  refer  to  the  Cash  account  shown  on  page  62.  The  first 
credit  entry,  $600,  under  date  of  January  2,  was  posted  from  page 
3  of  the  journal  (as  indicated  by  the  J3).  The  original  entry 
which,  it  may  be  assumed,  corresponds  to  this  posting  is  shown 
in  the  section  of  a  journal  page  on  page  60.  The  figure  7  ap- 
pearing in  the  column  at  the  left  of  the  journal  page  indicates  the 
ledger  page  on  which  is  found  the  Cash  account.  The  $600  item 
in  the  debit  journal  column  is  posted  to  the  debit  side  of  the  Mate- 
rials account  which  is  found  on  ledger  page  28.  The  ledger 
pages  noted  in  the  journal  and  the  journal  pages  listed  concur- 
rently in  the  ledger  accounts  serve  as  a  check  for  the  bookkeeper 
to  indicate  which  transactions  have  been  posted  and  to  correlate 
the  two  books  for  future  reference. 

In  connection  with  controlling  accounts  such  as  Accounts 
Payable  and  Accounts  Receivable  the  amounts  affected  must 
be  posted  twice  —  first  to  the  controlling  account,  and  second 
to  the  special  creditor's  or  customer's  account  as  the  case  may  be. 
In  the  last  transaction  shown  above,  for  example,  Accounts 
Receivable  was  credited  with  $50.  In  posting  this  transaction 
it  would  be  necessary  not  only  to  enter  an  item  of  $50  in  the 
right-hand  column  of  Accounts  Receivable  —  the  controlling 
account,  but  to  carry  the  same  amount  to  the  credit  of  the  H. 
A.  Wilcox  account.  This  is  an  apparent  exception  to  the  prin- 
ciple that  in  every  transaction  the  debit  entries  involved  equal 
the  credit  entries.  In  reality  it  is  no  such  exception ;  for  this 
situation  simply  means  that  certain  information  is  posted  in  dupli- 
cate. The  labor  of  posting  in  such  cases  is  very  much  reduced 
by  the  use  of  the  special-column  journal. 

If  all  the  transactions  are  correctly  posted  the  ledger  columns 


76  PRINCIPLES  OF  ACCOUNTING 

exactly  represent  the  debit  and  credit  classification  of  the  journal, 
and  the  total  of  all  debit  items  equals  the  total  of  all  credit  en- 
tries. In  other  words  the  opposite  columns  of  the  ledger  are  in 
balance.  This  applies  only  to  the  general  ledger,  for  obviously 
if  any  journal  item  is  posted  to  two  ledgers  the  equality  of  col- 
umns —  including  both  books  —  is  not  maintained. 

Where  the  journal  is  of  the  simple  form  described  in  this  chap- 
ter —  having  but  two  columns,  one  for  debits  and  one  for  credits 
-  posting  is  obviously  a  tedious  process.  Each  entry  must  be 
taken  separately ;  for  every  debit  in  the  journal  there  must  be 
a  debit  item  posted  to  some  ledger  account,  and  for  every  credit 
journal  entry  there  must  be  a  separate  credit  posting.  And  where 
controlling  accounts  are  used  there  are  two  debits  or  two  credits 
as  the  case  may  be.  To  reduce  the  clerical  work  involved  in 
this  process  is  one  of  the  main  reasons  for  the  development  of  the 
technique  of  bookkeeping,  and  some  very  ingenious  special  forms 
have  been  devised  to  eliminate  a  part  of  this  clerical  labor.  In 
the  following  chapter  the  way  in  which  the  process  of  posting 
can  be  abridged  by  the  use  of  special  forms  will  be  explained. 


DEVELOPMENTS  IN  TECHNIQUE 

THE  simple  forms  of  journal  and  ledger  described  in  the  last 
chapter  have  been  supplemented  in  large  measure  by  improved 
types  of  records.  These  books  are  not  sufficiently  specialized 
to  cover  the  various  phases  of  a  large  business  and  to  allow  a 
large  staff  of  bookkeepers  to  work  on  them.  Further,  the  process 
of  posting  from  the  simple  journal  is  laborious  and  much  time 
and  effort  may  be  saved  by  the  newer  forms.  These  develop- 
ments in  the  technique  of  double-entry  do  not  in  any  way  change 
the  principles  of  debit  and  credit  already  explained.  All  trans- 
actions must  be  recorded  in  some  form  of  record  and  analyzed 
into  debit  and  credit  items,  and  a  tabulation  must  finally  be  made 
of  the  debits  and  credits  by  ledger  accounts.  The  detail  process 
of  effecting  these  purposes,  however,  may  vary  according  to  the 
conditions  within  the  enterprise.  Some  of  the  more  common 
of  the  modern  forms  will  be  described  in  this  chapter. 

THE    SPECIAL-COLUMN   JOURNAL 

A  very  simple  modification  of  the  older  type  of  journal,  but  one 
which  effects  a  great  saving  in  the  labor  of  posting,  is  the  special- 
column  journal.  In  such  a  journal  the  debit  and  credit  columns 
of  the  simple  journal  are  subdivided  and  headed  with  the  names 
of  special  accounts.  The  items  in  these  special  columns  are 
posted  in  total  rather  than  individually.  Cash,  for  example,  is 
an  account  which  is  debited  and  credited  frequently  in  connec- 
tion with  current  transactions.  The  posting  process  may  be 
abridged  through  the  use  of  two  special  columns  for  this  account 
—  one  for  debit  entries,  and  one  for  credit  entries.  Two  post- 
ings will  then  serve  to  transfer  all  the  cash  entries  to  the  ledger. 
This  in  brief  is  the  principle  of  the  special-column  journal. 
The  following  illustration  of  one  type  of  special-column  journal 
shows  the  method  of  entry  and  of  posting.1 

1  Explanations  follow  the  entries  for  the  first  two  transactions  but  are  omitted 
thereafter.  The  student  can  readily  assume  transactions  which  might  give  rise 
to  the  remaining  entries. 

77 


PRINCIPLES  OF  ACCOUNTING 


fl! 

\O                 co 

8 

En 

siii 

1 

O               O 

CO                  IO 

-5 

1 

§                                                          § 
co 

8 

— 

C/3  Q 

o" 

§ 

6 

00 

%                 8 
pE 

I               3 

s|          * 

"     '1  e                                       8 

e         D".t3                         "O              X         ^         co              ^-             to                         x 

*  «N        §    a  la                   5   - 

rt                          .            T3       fr  ^                                                            T3          w 
T3«                    boc^D                                                 CM 

aj  •*;                                                  T3   C 
i>   O                                   <u  "         c   rt                                        C              m  TJ          O. 
p^*j<u                        2Ji3o3..>rbO                                            r/>j3o 

il  Ifil  b  b  li    1  SI  M  i 

^S    -sS°-S    1s"    '5H     s       *m    J"    1H     s 

!2>?5'S         —        C                                             <2W                               >- 
•         «4         V   3         3        JZ               9                                  rt                                                     O 

U           £           ««           PH^fa<Ol-AS                     (t, 

«M* 

<O                 «                                                 't                     \O 

*» 

>H            ««>          >>       ^>       ">>      >^      »      >> 

&I 

£g 

10  o"                                      co 

M     CS 

8 

HH 

GO 
CO 

m 

U 

§o 
co 

o" 

0 

5 

0 

bi 

1 

8                                        8 

H,                                                                   "^ 

Q 

0 
I/I 

>o~ 

ifjji 

o 

0 

*IJ 

0 
U 


DEVELOPMENTS   IN   TECHNIQUE 


79 


23       g 

6  z  <        10 


O  O 

00  vO 


O 
oo 


u 


U 


U 


U 


•Jfe 


8o 


PRINCIPLES  OF  ACCOUNTING 


,ei 

8 

O                                                                     »o 

10                                                                                                  J^ 

,0 

*M 

•I 

ir, 

o" 

"ft. 

w 

4|JJ 

O  «o 

10  M 

* 

1 

10 
H 

»o 

to 

M 

to 

M 

to 

a                 a 

10 

00 

M 

< 

w 

^ 

u 

M 

•<»• 

0 

o        o 

10 

00 

i?o 

N 

g 

5  H 

M      8 

10 

MJ 

0 

in  a 

nT 

IH 

0 

g 

Tj- 

'* 

— 

rt   rt 

rt    rt    rt 

rt    rt 

3 

O   0 

O    O    O 

O    O 

c 

-  <s 

C    C    C 

C    C 

d 

£  E 

E  E  E 

£    E 

§ 

3   3 

333 

3    3 

3 

O    O 

O    O    O 

O    O 

3 

uuuuuuuu 

to 

n 

o  H                                         M       d 

"rt 

B 

U  c               ?                         ^0                  <o 

-2 

3 

•    rt                                                       4^                  •                        *"o 

4^ 

^ 

a 

t£f~*     c                         IB         «£P           Ji  8j 

W 

i> 

B 

S                        o                 5          S             "^  •— 

05 

orwarded  fro 
erchandise 

1  f-!  Ll  i  ll  ^ai 

rt               —    -         *jt/3trt            *r          Hrt             t/i-*->-*-» 
EJ                    u         ucj-—            O         rtt!            rtflC 
CO             hAO        <IOQ           Z       •?,  W           CJ33 
Ji                      4,                 -^                ii           —  '           O    O 

[erchandise 
ash 
Cash 

bales 
Accounts 

Accounts 

—  S 

U                    H                 U              S           PH          « 

^U 

»w»fc 

o           ^*o      *o                              o 

^ 

> 

>  >»  >>^>a   »  2> 

ro  rt 

tovO  ^O 

r-t 

-0 

I    tfl 

ge 

to 

O          O   to 

to  to 

N  00 

10  n- 

| 

0 

00 

0 

^^ 

8 

M 

H 

0 

to                                    0 

\o                                 Q 

10 

00 

U 

^ 

M 

H* 

o  o 

to 

1 

S 

« 

_  2fcw 

10 

1O 

u  Z  W  i4 

8a! 

Ji 

§o 
o 
to 

8 

*N 

o" 

J 

o 
u 

a 
Q 


DEVELOPMENTS  IN  TECHNIQUE  81 

Special  debit  columns  are  maintained  in  this  illustration  for 
Cash,  Merchandise,  Accounts  Receivable  and  Accounts  Payable, 
and  special  credit  columns  for  Cash,  Sales,  Accounts  Re- 
ceivable and  Accounts  Payable.  Whenever  a  transaction  re- 
quires an  entry  to  one  of  these  accounts,  the  amount  is  entered 
in  the  appropriate  special  column.  When  entries  must  be  made 
to  other  accounts,  the  amount  is  entered  in  the  "sundries"  debit 
or  "  sundries  "  credit  column  as  the  case  may  be.  These  columns 
are  posted  item  by  item  in  the  manner  described  in  the  preceding 
chapter. 

An  explanation  of  a  few  of  the  illustrative  entries  shown  above 
will  serve  to  explain  the  nature  and  use  of  this  journal.  The 
first  pair  of  entries  shows  the  investment  of  $40,000  cash  in  a 
business  by  the  proprietor ;  consequently  there  is  a  debit  to  Cash 
and  a  credit  to  the  proprietor's  account.  The  debit  item  is  en- 
tered in  the  cash  column.  A  check  mark  is  immediately  placed 
in  the  ledger-folio  column  to  serve  as  a  reminder  to  the  book- 
keeper that  this  item  will  not  be  posted  separately.  A  special 
column  is  not  maintained  for  credits  to  the  proprietor's  account ; 
therefore  the  entry  for  this  part  of  the  transaction  is  made  in  the 
sundries  credit  column  and  no  check  mark  is  placed  in  the  ledger- 
folio  column.  This  entry  will  be  posted  separately  and  the  ledger 
page  on  which  is  found  the  proprietor's  account  will  be  entered 
in  the  folio  column. 

In  the  second  transaction  debits  are  made  to  two  accounts 
for  which  special  columns  are  not  maintained.  The  debit 
amounts  involved,  real  estate  $15,000  and  building  $20,000, 
are  placed  in  the  sundries  debit  column  and  are  posted  to  the 
ledger  accounts  affected  separately.  The  credit  to  Cash,  $35,000, 
is  entered  in  the  special  credit  column  for  Cash  and  a  check 
mark  is  placed  in  the  ledger-folio  column  as  before. 

The  third  entry  records  the  purchase  of  merchandise  amount- 
ing to  $6,000  on  account.  Both  the  debit  and  credit  items  for 
this  transaction  are  entered  in  special  columns  and  check  marks 
are  placed  in  the  ledger-folio  columns.  Had  this  purchase  been 
made  for  cash  the  debit  item  would  have  been  handled  in  the  same 
way  but  the  credit  entry  would  have  been  listed  in  the  cash  credit 
column. 

All  entries  are  made  according  to  the  method  shown  in  these 


82  PRINCIPLES  OF  ACCOUNTING 

transactions.  The  columns  reserved  for  sundries  are  used  for 
making  entries  affecting  accounts  for  which  special  columns  are 
not  maintained  and  the  items  in  these  columns  are  posted  sepa- 
rately. All  other  entries  are  listed  in  the  appropriate  special 
columns.  The  total  of  each  special  column  is  carried  forward 
to  the  end  of  the  period  covered  by  each  posting  —  a  month  in 
this  case,  it  may  be  assumed.  For  example,  the  total  of  the 
cash  debit  column,  $47,485,  is  brought  over  to  the  sundries 
column  and  from  there  is  posted  to  the  ledger  just  as  is  any 
other  sundry  item.  This  one  posting  carries  all  of  the  items 
in  the  column  for  cash  debits  to  the  ledger  in  one  sum. 
The  operation  of  posting  the  remaining  special  columns  is 
similar. 

That  this  form  of  journal  effects  a  great  saving  in  posting  is 
evident  even  from  the  above  simple  illustration.  The  total  num- 
ber of  entries  made  in  special  columns  is  thirty-nine,  while  the 
number  of  postings  from  these  columns  is  eight,  making  a  saving  of 
thirty-one  postings.  Since  the  ledger  accounts  show  just  as  much 
information  as  they  would  if  the  simple  journal  were  used,  this 
may  be  considered  a  net  saving.  In  the  case  of  an  enterprise 
where  the  entries  run  into  the  hundreds  per  day,  the  cost  of  keep- 
ing books  would  be  very  materially  reduced  by  such  a  method. 

The  extent  to  which  the  special-column  principle  may  be 
carried  is  practically  unlimited.  There  could  be  special  columns 
in  the  journal  for  each  ledger  account.  In  this  case  the  postings 
would  be  made  in  totals  to  all  accounts.  Such  a  procedure  would 
be  inadvisable,  however,  as  there  are  some  accounts  in  which 
only  one  or  two  entries  at  the  most  are  made  in  a  single  period. 
The  use  of  special  columns  for  such  accounts  would  not  only  fail 
to  save  work  in  posting  but  would  make  necessary  the  use  of  an 
unduly  large  book,  which  in  the  end  would  actually  increase  the 
work  of  the  bookkeeper. 

The  possibility  for  labor  saving  is  often  dependent  upon  the 
use  of  controlling  accounts  and  subsidiary  ledgers.  The  general 
significance  of  the  controlling  account  was  explained  in  the  last 
chapter  and  in  the  journal  above  this  principle  is  illustrated  for 
Accounts  Receivable  and  Accounts  Payable.  The  total  amount 
receivable  on  customers'  accounts  constitutes  one  distinct  asset 
item  for  balance  sheet  purposes.  The  amount  due  from  an 


DEVELOPMENTS  IN  TECHNIQUE  83 

individual  customer  is  of  little  importance  in  the  presentation  of 
a  statement  showing  a  firm's  financial  condition.  It  is  the  sum- 
mary of  all  the  customers'  accounts  that  is  significant.  It  is 
obvious  that  for  other  purposes,  however,  a  knowledge  of  the 
amounts  due  from  individual  customers  must  be  available.  In 
order  to  serve  both  of  these  purposes  the  controlling  account  is 
used.  That  is,  an  account  is  kept  in  the  general  ledger  called 
"Accounts  Receivable"  in  which  the  debits  and  credits  to  all 
customers  are  entered.  In  addition  to  this  a  special  ledger  called 
the  customers'  or  sales  ledger  is  used  in  which  a  separate  account 
with  each  customer  is  kept.  The  general  ledger  account  is  used 
for  obtaining  the  information  for  financial  statements  while  the 
customers'  ledger  is  used  for  the  detailed  information  concerning 
each  customer's  account.  This  procedure  necessitates  the  enter- 
ing of  the  same  information  in  duplicate.  A  saving  is  effected 
by  placing  all  debits  and  credits  to  the  controlling  account  in 
special  columns  in  the  journal  and  posting  in  total  from  these 
columns  to  the  general  ledger  account.  Two  postings  to  the 
controlling  account  are  all  that  are  required  for  each  accounting 
period. 

The  separate  amounts  must  be  posted  to  the  customers'  ledger 
in  order  that  each  individual's  account  will  always  show  the 
balance  due.  There  are  various  methods  used  in  practice  in 
making  these  postings.  In  the  illustration  given,  two  ledger- 
folio  columns  are  employed,  one  for  general  ledger  postings,  the 
other  for  subsidiary  ledger  postings.  Take,  for  example,  the 
entries  under  date  of  January  5th.  On  this  date  J.  R.  Kerwin 
purchased  goods  amounting  to  $50  on  account.  This  transaction 
requires  a  debit  to  Accounts  Receivable  in  the  general  ledger  and 
an  item  of  $50  is  entered  in  the  accounts  receivable  debit 
column.  An  entry  of  $50  must  also  be  made  to  J.  R.  Kerwin's 
account  in  the  customer's  ledger.  J.  R.  Kerwin's  name  is  entered 
on  the  line  used  for  the  name  of  the  account  to  be  debited.  At 
the  time  for  posting,  the  $50  item  is  posted  to  his  account  in  the 
customers'  ledger  and  the  ledger  page  is  entered  in  the  ledger- 
folio  column  reserved  for  subsidiary  ledger  entries.  A  great 
many  improvements  have  been  made  in  the  customers'  ledger 
which  have  simplified  the  process  of  posting  to  that  book.  In  fact 
systems  have  been  devised  which  eliminate  this  work  altogether. 


84  PRINCIPLES  OF  ACCOUNTING 

A  discussion  of  these  methods  will  be  deferred  to  a  later  section 
of  this  chapter,  however. 

What  has  been  said  with  regard  to  customers'  accounts  may 
be  applied  in  principle  to  the  creditors'  accounts.  In  this  case 
the  general  ledger  account  is  called  '*  Accounts  Payable"  ;  the 
subsidiary  ledger  is  called  the  creditors'  or  purchase  ledger.  In 
fact  the  controlling  account  device  may  be  used  wherever  sum- 
mary information  is  desired"  for  one  purpose  and  detailed  infor- 
mation for  another.  In  a  complex  system  of  accounts  for  a  large 
enterprise  practically  every  general  ledger  account  controls  a 
subsidiary  ledger. 

In  the  special-column  journal  of  the  above  illustration  the 
entries  were  made  in  the  conventional  form  described  in  Chapter 
IV.  That  is,  the  debit  account  was  written  on  one  line  and  the 
credit  account  was  placed  on  the  next  line  slightly  indented  to 
the  right.  The  entries  for  cash  sales,  for  example,  were  made 
in  this  form : 

50  Cash 

Sales  50 

In  actual  practice  a  bookkeeper  shortens  the  entry,  writing  it  as 
follows : 

50  Cash  Sales  50 

The  $50  item  at  the  left  is  entered  in  the  cash  debit  column ; 
that  at  the  right  is  listed  hi  the  sales  column.  Since  both  en- 
tries are  recorded  in  special  columns,  one  line  may  be  used  as 
just  explained  without  causing  confusion.  Many  bookkeepers 
who  have  become  adept  in  the  use  of  special-column  journals 
find  it  convenient  to  place  all  special-column  entries  for  one  day's 
business  on  a  single  line.  One  case  is  known  in  which  a  book- 
keeper made  all  the  journal  entries  for  a  month  on  one  page. 
He  had  made  a  wise  choice  of  special  columns  and  had  been  able 
to  place  most  of  his  entries  for  each  day  on  a  single  line.  Of 
course  when  this  policy  is  pursued  it  is  essential  that  all  original 
documents  such  as  sales  memoranda  should  be  kept  in  a  con- 
venient file  for  reference. 


DEVELOPMENTS  IN  TECHNIQUE  85 

THE   CASH   BOOK 

Another  device  for  simplifying  the  work  of  the  bookkeeper 
consists  in  the  use  of  specialized  journals.  Each  special  journal 
is  used  for  the  recording  of  entries  resulting  from  a  single  type 
of  transaction  such  as  cash  receipts  and  disbursements,  sales,  and 
purchases.  The  cash  book,  as  is  suggested  by  its  title,  is  used 
for  recording  all  entries  affecting  cash.  Transactions  for  which 
either  a  debit  or  credit  to  Cash  is  required  are  entered  in  this 
journal,  and  no  other.  This  book  may  be  used  in  a  system  of 
journals  consisting  of  an  old  style  journal  and  cash  book,  a 
special-column  journal  and  cash  book,  or  several  books  of 
original  entry  such  as  purchase  book,  sales  book,  ordinary  jour- 
nal, etc.,  including  the  cash  book.  The  construction  of  the  cash 
book  is  not  primarily  dependent  upon  the  types  of  journals  used 
for  other  original  entries  and  may  therefore  be  discussed  inde- 
pendently. The  illustration  on  pages  86  and  87  will  serve  as  a 
basis  for  this  discussion. 

The  left-hand  page  is  a  complete  journal  for  all  transactions 
recognizing  the  receipt  of  cash,  while  the  right-hand  page  is  a 
complete  journal  for  all  transactions  involving  disbursements. 
Except  for  the  fact  that  only  cash  transactions  are  entered,  the 
cash  book  is  the  same  in  principle  as  the  special-column  journal. 
The  entries  are  made  in  much  the  same  manner  and  the  process 
of  posting  is  essentially  the  same.  For  example,  whenever  cash 
is  received,  the  amount  received  is  entered  in  the  cash  debit 
column  on  the  left-hand  page  and  the  credit  item  is  entered  in 
the  appropriate  credit  column  on  the  same  page.  If  the  credit 
entry  is  to  some  account  for  which  a  special  column  is  kept,  for 
example,  Accounts  Receivable  or  Sales,  the  amount  involved 
is  entered  in  the  column  headed  by  the  name  of  the  appropriate 
account  and  a  check  mark  is  placed  in  the  ledger-folio  column 
opposite  the  entry.  If  the  credit  is  to  an  account  such  as  Capital 
Stock  the  amount  is  entered  in  the  sundries  credit  column.  The 
items  in  this  column  are  posted  separately.  The  same  things 
may  be  said  of  the  right-hand  page,  except  that  this  side  is  used 
for  recording  cash  payments.  Credits  to  the  Cash  account  are  en- 
tered in  the  cash  column  and  the  corresponding  debits  are  placed 
either  in  one  of  the  special  columns  or  in  the  sundries  debit  column. 


86 


PRINCIPLES  OF  ACCOUNTING 


" 


ON 
O 


rs  10        M 


o  o 

to  o 

M     CS 


' 


*s 

|-H 


iifjUkH  U>S  HHH 


<u  . 

3 


C/jJfc.  ^><» 


, 
PQ 


UH 


DEVELOPMENTS   IN  TECHNIQUE 


si2 
Cfi 


Xj  o 

6u 
_  -«-H 

O     Q 

§!' 

o'S 


o 

M 

$ 

jy 

•fil  I 


a  c  c 
S  6  S 

p   3   S   3  ^3 

0*3*3  "3  "3 


<UOO"4-i  O          ^OUUUUVJ 


. 

<-> 


^     -5      rt 


—  1)   £H 


o 

3  "^* ' 

"^  "o 


S    £O;HHHHHO 


«£f     u 


*« 

tn  <u 

^^5 
^  "S 


88  PRINCIPLES  OF  ACCOUNTING 

It  will  be  noticed  that  a  discount  debit  column  appears  on  the 
left-hand  page  and  a  discount  credit  column  on  the  right-hand 
page.  These  columns  are  used  to  simplify  the  recording  of  cash 
discounts  on  customers'  and  creditors'  accounts  respectively. 
The  transactions  which  give  rise  to  the  cash  discount  accounts 
were  explained  in  Chapter  IV.  An  illustration,  however,  will 
be  needed  at  this  point  to  make  clear  the  necessity  for  the  special 
discount  columns  in  the  cash  book.  A  bill  of  goods  is  sold  on 
February  loth  at  an  invoice  price  of  $300,  with  an  allowance  of 
two  per  cent  if  settled  in  ten  days.  The  firm  making  the  sale 
would  charge  the  customer  with  the  amount  of  invoice  on  Feb- 
ruary loth,  making  the  following  entries : 

Accounts  Receivable $300 

Sales $300 

If  the  customer  takes  his  discount  on  February  2oth  the  actual 
cash  received  is  $294,  and  this  amount  is  accepted  in  full  settle- 
ment of  the  amount  originally  charged  to  Accounts  Receivable. 
The  necessary  journal  entries  to  recognize  this  situation  on  the 
books  would  be: 

Cash $294 

Sales  Discounts . 6 

Accounts  Receivable $300 

Since  these  entries  represent  essentially  a  cash  transaction,  pro- 
vision should  be  made  in  the  cash  book  for  the  complete  entry. 
This  is  accomplished  by  the  use  of  a  special  column  on  the  re- 
ceipts side  headed  "Sales  Discounts  Dr. "  The  actual  amount  of 
cash  received  is  entered  in  the  cash  debit  column,  the  discount  in 
the  discount  column  and  the  credit  to  Accounts  Receivable  in  the 
accounts  receivable  column,  and  since  all  items  are  entered  in 
special  columns,  a  check  mark  is  placed  in  the  ledger-folio  column 
opposite  the  entry. 

The  discount  column  on  the  disbursements  side  is  for  purchase 
discounts.  The  entry  on  February  i5th  illustrates  the  use  of 
this  column.  It  may  be  assumed  that  on  January  isth  the  firm 
purchased  materials  at  an  invoice  price  of  $1,000  with  an  allow- 
ance of  two  per  cent  for  payment  within  thirty  days.  The 
entries  would  be : 


DEVELOPMENTS  IN  TECHNIQUE  89 

Materials $1,000 

Accounts  Payable $1,000 

Then  on  February  i5th  when  payment  is  made,  the  journal 
entries  would  be : 

Accounts  Payable $1,000 

Cash $980 

Purchase  Discounts 20 

These  latter  entries  must  be  made  on  the  disbursements  side  of 
the  cash  book,  and  a  special  column  should  be  provided  for  the 
credit  to  Purchase  Discounts.  If  the  cash  book  were  used,  how- 
ever, entries  covering  this  case  would  be  made  by  placing  the 
cash  payment  in  the  cash  credit  column,  the  discount  in  the  dis- 
counts credit  column,  and  the  sum  of  the  two  in  the  accounts 
payable  debit  column. 

One  line  is  usually  sufficient  for  recording  a  complete  trans- 
action in  the  cash  book.  On  the  receipts  side  all  debit  entries 
are  placed  in  special  columns ;  no  occasion  arises  for  the  use  of  a 
sundries  debit  column ;  and  hence  there  is  no  need  of  naming  the 
accounts  to  be  debited  as  the  fact  that  the  transaction  is  entered  in 
the  receipts  side  means  that  Cash  (or  Cash  and  Sales  Discounts)  is 
debited.  The  name  of  the  account  to  be  credited  must  be  stated, 
however,  and  this  is  placed  in  the  column  headed  "  Accounts  to 
be  credited."  On  February  ist,  for  example,  the  name  Capi- 
tal Stock  was  entered  in  this  column,  and  an  item  of  $20,000 
on  the  same  line  in  the  sundries  credit  column.  This  means  that 
$20,000  must  be  posted  to  the  credit  of  Capital  Stock.  The 
same  amount  is,  of  course,  also  entered  in  the  cash  debit  column. 
Thus  the  entries  for  the  complete  transaction  are  made  on  a 
single  line.  The  same  thing  is  true  of  the  disbursements  side 
except  that  here  the  credit  entries  are  always  made  in  the  cash 
credit  column  (and  discount  credit  column  where  necessary), 
and  the  name  of  the  account  to  be  debited  is  placed  in  the  proper 
column  on  the  same  line. 

The  column  totals  are  posted  in  a  manner  similar  to  the  process 
described  for  the  special-column  journal.  Postings  to  subsidiary 
ledgers  are  also  made  in  much  the  same  manner.  The  name  of 
the  customer's  account  to  be  credited  for  a  cash  receipt,  for  ex- 


QO  PRINCIPLES  OF  ACCOUNTING 

ample,  is  entered  in  the  column  headed  "  Accounts  to  be  credited." 
A  check  mark  is  placed  in  the  general  ledger-folio  column,  as  the 
posting  to  the  controlling  account  will  be  made  in  column  total. 
When  the  proper  amount  is  posted  to  the  credit  of  the  individual 
customer's  account  the  number  of  the  ledger  page  is  placed  in 
the  subsidiary  ledger-folio  column. 

As  a  final  consideration,  mention  should  be  made  of  the  possi- 
bility of  using  the  cash  columns  in  place  of  a  cash  account  in  the 
general  ledger.  It  will  readily  be  seen  that,  since  all  cash  receipts 
are  entered  in  the  cash  debit  column  and  all  cash  payments  in 
the  cash  credit  column,  these  two  columns  contain  all  the  infor- 
mation usually  given  in  a  cash  account  except  the  opening  bal- 
ance. This  figure  may  be  placed  on  the  receipts  side  on  the  first 
day  of  each  period  following  the  closing  of  the  accounts  and  the 
closing  balance  on  the  disbursements  side  immediately  preceding 
the  closing  of  the  accounts.  When  this  is  done,  no  cash  account 
is  kept  in  the  general  ledger.  The  process  of  closing  accounts 
will  be  fully  discussed  in  a  later  chapter. 


THE    SALES   BOOK 

Sales  transactions  constitute  another  distinct  phase  of  the 
business  and  therefore  usually  form  the  basis  for  another  special- 
ized journal.  Like  the  cash  book,  this  journal  as  generally  con- 
structed is  in  the  nature  of  a  special-column  journal,  the  entries 
in  this  case  being  limited  to  credit  sale  transactions.  The  table 
on  page  91  is  an  illustration  of  a  typical  sales  book  page. 

There  are  two  debit  and  three  credit  columns  in  this  sales  book. 
The  debits  for  sales  transactions  will  generally  be  made  to  Ac- 
counts Receivable  since  most  sales  are  on  open  book  account. 
One  debit  column  is  therefore  maintained  for  Accounts  Receiv- 
able. A  sundries  debit  column  is  used  for  debits  to  the  accounts 
involved  when  the  sale  is  not  made  on  open  book  account.  The 
sales  on  February  i$th  and  2oth,  for  example,  were  made  for 
promissory  notes.  The  debit  in  each  case  was  to  Notes  Re- 
ceivable and  was  entered  in  the  sundries  column.  The  items  in 
the  sundries  column  are  posted  separately,  the  other  columns  are 
posted  in  total. 


DEVELOPMENTS  IN  TECHNIQUE 


DATE 

L 
F 

s 

L 
F 

NAME  OF  ACCOUNT 
TO  p":  DEBITED 

EXPLANATION 

SUN- 
DRIES 
DR. 

AC- 
COUNTS 
RECEIV- 
ABLE 
DR. 

SALES 
DEPT.  A 
CR. 

SALES 
DEPT.  B 
CR. 

SALI 
DEPT 
CR. 

Feb 

i 

V 

'5 

J.  B.  Crane 

Inv.  i  Terms  5-30 

240 

130 

no 

V 

6 

A.  B.  Woods 

Inv.  2  Terms  2-10 

150 

1  20 

30 

3 

V 

18 

J.  B.  Parker 

Inv.  3  Terms  1-30 

215 

35 

1  80 

V 

54 

A.  M.  Spencer 

Inv.  4  Terms  2-10 

75 

30 

45 

7 

V 

4 

Bennet  and  Co. 

Inv.  5  Terms  1-30 

215 

IOO 

75 

40 

10 

V 

12 

McGuire  Supply  Co. 

Chicago  Inv.  6  n-6o 

i?5 

I7S 

15 

10 

Notes  Receivable 

R.  M.Jones  &  Co. 

235 

70 

35 

130 

for  Inv.  7 

17 

V 

36 

L.  M.  Hayes 

Inv.  8  Terms  n~3O 

125 

IS 

10 

IOO 

20 

10 

Notes  Receivable 

M.    A.    Pierson  on 

Inv.  9 

185 

no 

50 

25 

2.5 

x/ 

98 

Fred  J.  Jevons 

Inv.  10  Te  ms  2-10 

38s 

210 

120 

55 

25 

V 

s 

Kane  Webster  &  Co. 

Inv.  ii  Te  ms  2-30 

256 

125 

31 

IOO 

26 

V 

I  ,S 

J.  B.  Crane 

Inv.  12  Te  ms  3-30 

195 

75 

120 

27 

V 

45 

L.  N.  Keller 

[nv.  13  Te  ms  2-10 

360 

45 

3i5 

V 

7 

Carter  and  Watt 

Inv.  14  Te  ms  1-30 

1  60 

25 

35 

IOO 

28 

V 

21 

A.  K.  Rawlins 

[nv.  15  Terms  n-3o 

225 

US 

IOO 

IO 

V 

63 

Ellis  Baker  &  Co. 

[nv.  16  Terms  2-30 

75 

15 

60 

V 

8 

K.  V.  Harvey 

[nv.  17  Terms  1-30 

215 

25 

95 

95 

V 

24 

Albert  Peters  Co. 

[nv.  1  8  Terms  n~3o 

135 

76 

59 

IS 

Accounts  Receivable 

Total  of  column 

3,201 

Dr. 

25 

Sales  Dept.  A      Cr. 

Total  of  column 

1,241 

27 

Sales  Dept.  B       Cr. 

Total  of  column 

966 

29 

Sales  Dept.  C      Cr. 

Total  of  column 

= 

= 

1,414 

Cash  sale  transactions  are  not  recorded  in  this  book.  Such 
transactions  must  be  entered  in  the  cash  book  anyway  if  the  cash 
columns  are  used  for  a  cash  account.  A  sales  column  (or  col- 
umns) on  the  receipts  side  of  the  cash  book  makes  the  posting 
of  the  credit  sales  entries  very  simple.  To  enter  such  transactions 
in  the  sales  book  also  would  entail  needless  duplication.  It  is 
sometimes  urged  that  the  sales  book  should  include  cash  sales  so 
that  the  total  of  all  sales  maybe  in  one  place.  This  information 
can  be  readily  ascertained,  however,  by  adding  the  cash  book  and 
sales  book  figures  together  or  by  reference  to  the  Sales  account 
after  both  journals  have  been  posted. 

The  three  credit  columns  are  for  the  sales  accounts  for  the 
three  hypothetical  departments  of  this  business.  Departmental 
sales  accounts  are  of  importance  for  comparative  purposes. 
Often  a  separate  sales  organization  is  maintained  for  each  of  the 
different  departments  and  in  such  cases  these  accounts  serve  to 
inform  the  manager  of  results  attained  by  the  departmental 
heads.  In  any  case  a  knowledge  of  the  sales  by  departments  is 
of  importance  for  managerial  purposes. 


92  PRINCIPLES  OF  ACCOUNTING 

The  posting  process  is  the  same  as  for  the  other  journals  al- 
ready described.  Special  columns  are  posted  in  total  with  ledger 
pages  entered  in  the  appropriate  column.  The  customers' 
ledger  pages  are  entered  in  the  second  ledger-folio  column. 


THE    PURCHASE    BOOK 

This  book  is  kept  for  the  purpose  of  recording  the  same  kind 
of  information  in  regard  to  purchases  as  the  sales  book  shows 
for  sales.  The  form  of  a  purchase  book  is  essentially  the  same 
as  that  of  a  sales  book  except  that  the  debits  are  to  materials  or 
merchandise  accounts  and  the  credits  mainly  to  Accounts  Payable 
instead  of  Accounts  Receivable  and  Sales  respectively  as  for  the 
latter.  A  page  from  a  purchase  book  might  appear  somewhat 
as  follows : 


DATE 

L 
1 

s 

L 
F 

NAME  OF  ACCOUNT 
TO  BE  CREDITED 

EXPLANATION 

SUN- 
DRIES 
CR. 

AC- 
COUNTS 
PAY- 
ABLE 
CR. 

MER- 
CHAN- 
DISE 
DEFT. 
A.  DR. 

MER- 
CHAN- 
DISE 
DEPT. 
B.  DR. 

MEI 

CHAI 

DIS 

DEP- 
C.  D 

Feb. 

i 

V 

6 

The      Davenport 

Inv.  i  Terms  2-10 

215 

100 

15 

100 

Mfg.  Co. 

3 

V 

B 

The  Iowa  Supply  Co. 

Inv.  2  Terms  2-10 

365 

315 

So 

4 

V 

10 

The    Detroit    Ma- 

Inv. 3  i-3o/n-6o 

225 

200 

25 

chine  Co. 

• 

| 

5 

V 

5 

Grand  Rapids  Furn. 

Inv.  4  Terms  1-30 

195 

95 

25 

75 

Co. 

0 

V 

I" 

Barnes  Desk  Co. 

Inv.  s  Terms  2-30 

3,200 

1,980 

20 

1,200 

I? 

V 

32 

Muskegon  Furniture 

Inv.  6  1-30 

1,295 

895 

400 

Co. 

IS 

V 

ig 

Marshall  Table  Mfg. 

Inv.  7  Terms  2-10 

98s 

36s 

20 

600 

Co. 

i  i 

V 

45 

Smith  and  Black 

Inv.  8  Terms  5-30 

876 

676 

125 

75 

21 

V 

(.6 

Fetter  Lamp  Co. 

Inv.  9  Terms  2-10 

725 

725 

2J 

V 

71 

Grand  Haven  Piano 

Inv.  to  Terms  1-30 

350 

300 

15 

35 

Co. 

2; 

12 

V 

Notes  Payable 

Rochester  Glass  Co. 

-'50 

50 

75 

125 

6%  note 

24 

V 

6 

Davenport  Mfg.  Co. 

Inv.  12  Terms  1-30 

225 

75 

15 

135 

25 

V 

25 

Mallock  Hastings  & 

Inv.  13  Terms  11-30 

350 

350 

Co. 

a 

V 

23 

Shaw  Supply  Co. 

Inv.  14  Terms  2-10 

215 

100 

10 

105 

V 

32 

Electric  Iron  Co. 

Inv.  15  Terms  2-10 

1  60 

80 

40 

40 

V 

35 

Marshall  and  Field 

Inv.  16  Terms  1-30 

75 

IS 

00 

2; 

Accounts     Payable 

Total  of  column 

9,456 

Cr. 

1  6 

Merchandise   Dept. 

Total  of  column 

5,97i 

A                     Dr. 

[« 

Merchandise    Dept. 

Total  of  column 

1,220 

B                      Dr. 

21 

Merchandise    Dept. 

Total  of  column 

2,515 

C                       Dr 

DEVELOPMENTS  IN  TECHNIQUE  93 

All  purchases  of  merchandise  except  those  for  which  cash  is  im- 
mediately paid,  are  entered  in  this  book.  Cash  purchases 
like  cash  sales  are  entered  in  the  cash  book,  and  to  enter 
these  transactions  again  in  the  purchase  book  would  in- 
volve needless  duplication.  The  form  of  entry  is  the  same 
as  for  the  sales  book.  There  are  two  ledger-folio  columns, 
one  for  general  ledger  pages  and  one  for  the  creditors'  ledger 
pages.  The  first  money  column  is  for  sundry  items  and  is 
used  to  show  the  amounts  credited  to  accounts  for  which  no 
special  credit  columns  are  kept.  In  this  case  the  only  special 
credit  column  is  for  Accounts  Payable,  and,  as  most  purchases 
are  made  on  open  book  account,  most  of  the  entries  are  made  in 
this  column.  The  only  sundries  column  entry  in  the  illustration 
was  for  the  transaction  on  February  23rd  when  a  note  was  given 
for  the  purchase  of  $250  worth  of  merchandise.  This  amount 
was  credited  to  Notes  Payable  through  the  sundries  column. 

The  remaining  three  columns  are  for  debits  to  the  merchandise 
accounts.  Three  merchandise  accounts  are  shown  for  the  three 
departments  of  the  business  corresponding  to  the  sales  ac- 
counts as  shown  above.  It  is  customary  to  limit  the  purchase 
book  to  entries  recording  the  purchases  of  merchandise  (or  of 
materials  in  the  case  of  a  manufacturing  enterprise)  but  other 
items  such  as  labor  and  supplies  could  be  charged  here  if  special 
columns  were  kept  for  that  purpose.  The  process  of  posting  is 
essentially  the  same  as  from  the  sales  book. 

THE    VOUCHERS   PAYABLE    REGISTER 

The  charters  or  by-laws  of  a  great  many  corporations  provide 
for  the  incurring  of  liabilities  and  the  payment  of  the  same  only 
on  written  authorizations  of  certain  officers.  When  this  provi- 
sion obtains,  it  means  that  payments  may  be  made  only  to  cancel 
obligations  which  have  already  been  recognized  as  liabilities. 
Stated  in  another  way  it  means  that  all  purchases  —  from  the 
viewpoint  of  the  bookkeeper  —  are  made  on  open  account. 
Furthermore  it  is  customary  for  corporations  to  make  settle- 
ments of  creditors'  accounts  within  the  allowed  discount  period 
for  each  invoice.  These  facts  make  the  purchase  book  of  ex- 
ceptional importance  and  make  possible  its  use  for  other  pur- 


94  PRINCIPLES  OF  ACCOUNTING 

poses  than  those  mentioned  in  the  preceding  section.  This  is 
usually  accomplished  through  the  substitution  of  what  is  called 
a  vouchers  payable  register  for  the  purchase  book. 

A  detailed  description  of  a  vouchers  payable  register  can  best 
be  made  on  the  basis  of  the  illustration  of  a  page  from  such 
a  book  shown  on  page  95. 

The  first  column  after  the  date  in  this  book  is  headed  "Voucher 
No."  This  refers  to  the  number  of  the  voucher  on  which  the 
authorization  of  the  proper  official  is  placed.  Immediately  upon 
receipt  of  an  invoice  from  any  creditor,  the  bookkeeper  makes  out 
a  voucher  covering  the  invoice  and  sends  it  to  the  proper  official 
for  his  signature.  As  soon  as  the  voucher  is  signed,  it  is  entered 
in  the  vouchers  payable  register.  Each  voucher  is  given  a  num- 
ber. The  voucher  itself  is  then  placed  in  a  file  for  unpaid  vouch- 
ers where  it  is  kept  until  paid.  On  the  date  of  payment  it  is 
removed  from  this  file  ;  the  treasurer  is  instructed  to  draw  a  check 
for  the  amount ;  after  which  the  voucher  is  placed  in  another  file 
for  vouchers  paid.  This  same  routine  is  followed  no  matter  how 
short  the  time  between  receiving  the  bill  and  the  making  of  pay- 
ment. Even  the  entries  for  so-called  cash  transactions  are 
handled  according  to  this  procedure. 

In  the  series  of  columns  which  follow  the  voucher  number 
column,  the  name  of  the  party  to  whom  the  voucher  is  payable, 
the  address  and  a  statement  of  the  purpose  are  entered  to  further 
describe  the  voucher.  Entries  are  made  in  the  columns  headed 
''When  and  How  Paid"  at  the  date  of  payment.  The  unpaid 
voucher  file  constitutes  the  creditors'  ledger  and  no  other  credi- 
tors' accounts  are  kept.  This  saves  all  the  posting  to  the  credi- 
tors' ledger  usually  required  from  the  ordinary  purchase  book. 

All  of  the  remaining  columns  are  for  journal  purposes.  The 
first  money  column  is  headed  "Vouchers  Payable  Cr."  The 
total  amount  of  every  voucher  is  entered  in  this  column.  This 
recognizes  the  indebtedness  of  the  corporation  on  each  voucher 
at  the  time  it  is  properly  signed.  It  might  be  called  the  accounts 
payable  credit  column.  The  series  of  columns  immediately 
following  this  one  are  for  the  accounts  to  be  debited.  Special 
columns  arc  kept  in  this  case  for  three  departments  of  merchan- 
dise, and  for  Labor,  Advertising,  Fuel,  Freight,  and  General  Ad- 
ministrative Expense.  The  "  Sundry  Accounts  Dr."  column  is 


DEVELOPMENTS   IN   TECHNIQUE 


95 


1-JfcH 

>o                 oo        v> 

j.               jj 

1 

Jii         T3 

1  !•• 

Pi              (H      IH 

£H          3d 

g   f  J 

g           |     5fe 
rt           Is     fa 

C/3                                    * 

-        &    | 

sasNaaxg  aAixvai 

2     8 

III 

XHOI3HJ      £ 

e 

H£? 

I          <5 

in                                                                               00 

Sfe 

M  p. 

ONisixaaAay  Q 

8 

8_^ 
^ 

aoavT       « 

5 

88            2, 

M_               CO                                    -*t 

O  11^"^ 

?a£rca     (3 

8            8        8K 

H  ll*"—  ' 

a->£w1  (3 

»o                     O                O    lf> 

^ 

'asaj^       Q 

O                  oo             vo   r-  w 
M                  c£             ro  'O  t-*                                            a 

|g 

saanonoA     o 

i/ivoO^OOO          10  O    »o 

8O    Q    m  v>   O    O    O 
O    O    i>-  00    M    wo   0 

MO                             N     W      0 

o"  "  — 

§a       dl 

V>00v0^0vro^                  0« 

«  wo  •-     oo  o>  o 

00 

wo             "8 
siW             O 

OOOOOOOOOOOOOO                   0000 

00  00    00   00          00  00  00 

1    1    1    1    1    1    1           II 

WMM^OMIOOO                      Om 
i.      I     I      N      '        '       N                        N      " 

N      '       t      '                III 

£  T  ?  T      i,"J  J 

1 

X: 

—        E 

"3  00         T3 
>^  Tfc^t/j    ^        ^  ^ 

^B^*K4SMB£&BB 

(Sia^istS'sss 

3  ^^               3  W 

M&                         >>   0 

j>(      .  "^4  "§)        .2  J4  —  « 

»  ^  8  '»  §  a  v  g 

S^^fafa^^O 

I 

4 

•I  -^  . 
f      I?  -.53 

u  BCoo  bJ    I  J  1 

Jg    ^          ^p  43  tU 

Q            £  3     as  2  u 

X        _. 

o     ."3 

.M        S 

o      .«.y.^ 

g   luu 

?5      Q 

fe 

d        a 

^?    ^  jj 

2      1^1    c3* 

l|a  ill  Ms 

IlIlPl  ill 

^aitH  1-^ 

dH<(2u;6s    ^J^ 

i  raymaster 
2  Economy  Advertiser 
3  Paymaster 
4  M.  C.  R.  R. 
5  Ajax  Coal  Co. 
6  Bartlett  Supply  Co. 
7  Paymaster 
S  Cashier 

1 

M          to  «00         O>         « 

1 

S2      S?     'g'S 

96  PRINCIPLES  OF  ACCOUNTING 

placed  at  the  extreme  right  of  the  page.  Here  there  is  one  space 
for  the  amount,  one  for  the  name  of  the  account  to  be  debited, 
and  one  for  the  ledger  folio. 

A  slightly  different  method  of  posting  the  column  totals  is 
shown  here.  Instead  of  carrying  the  total  of  each  special  column 
over  to  the  sundry  column  for  posting  so  that  the  ledger  page  can 
be  entered  in  the  ledger-folio  column,  the  posting  is  made  directly 
from  the  column  total  and  the  ledger  page  is  placed  just  below 
the  total  in  parentheses,  thus,  (41).  This  procedure  has  the  advan- 
tage of  economizing  space  especially  when  several  special  columns 
are  used. 

When  the  vouchers  payable  register  is  used,  the  disbursements 
side  of  the  cash  book  can  be  very  greatly  simplified.  Since  every 
payment  must  be  made  on  an  authorized  voucher,  the  debit  for 
every  payment  must  be  to  the  Vouchers  Payable  account.  Three 
columns  then  are  sufficient,  vouchers  payable  debit,  discount 
credit,  and  cash  credit. 

SPECIALIZED   LEDGERS 

So  far  the  illustrations  of  technical  improvements  have  been 
concerned  primarily  with  journal  rulings.  More  progress  has 
been  made  in  simplifying  the  books  of  original  entry  than  those  of 
account,  but  some  of  the  modifications  in  the  ledger  are  of  suffi- 
cient importance  to  bear  mention  in  this  connection.  In  prac- 
tice the  general  ledger  accounts  are  usually  kept  in  the  form  shown 
in  the  last  chapter.  Sometimes,  however,  the  arrangement  of 
the  columns  is  changed  so  that  the  debit  and  credit  money  col- 
umns are  adjacent  and  a  third  column  is  added  for  the  purpose 
of  showing  the  balance  continuously.  Again,  the  ledger  is  often 
kept  in  a  loose-leaf  binder  in  order  to  keep  the  active  accounts 
in  compact  form  without  carrying  the  dead  or  inactive  accounts. 
The  general  ledger  usually  contains  a  great  many  controlling  ac- 
counts supported  by  subsidiary  ledgers.  In  fact  in  the  case  of  a 
large  corporation  nearly  every  general  ledger  account  controls 
some  subsidiary  ledger.  In  the  case  of  a  manufacturing  company, 
for  instance,  the  Buildings  and  Equipment  accounts  are  supported 
by  building  and  equipment  ledgers  having  detailed  records  of 
separate  buildings,  units  of  machinery,  and  equipment.  The 


DEVELOPMENTS  IN  TECHNIQUE  97 

manufacturing  and  sales  expense  accounts  are  supported  by 
factory  cost  ledgers,  etc.  These  are  detail  questions  which  pre- 
sent themselves  more  particularly  in  the  designing  of  systems  of 
records  for  specific  firms  and  generalizations  of  importance  cannot 
well  be  made.  The  customers'  ledger  is  common  to  most  enter- 
prises, however,  and  a  brief  discussion  of  modern  developments 
in  this  book  is  given  here. 

In  the  retail  merchandise  business  one  form  of  customers' 
ledger  has  been  almost  universally  adopted.  This  may  be  called 
the  slip  system,  although  the  specific  system  in  any  case  usually 
bears  the  name  of  the  manufacturer  who  produces  the  ledger 
forms.  The  salesman  makes  out  a  detail  slip  in  duplicate  or 
triplicate  at  the  time  of  making  a  sale  for  credit.  This  slip  gives 
the  name  of  the  customer  and  specifies  the  articles  sold  and  the 
amount  of  the  bill.  One  copy  is  given  to  the  customer  and  one 
is  kept  for  ledger  purposes.  All  of  these  credit  sales  slips  are 
added  up  at  the  end  of  each  day  and  one  journal  entry  is  made 
covering  all  credit  sales.  This  entry  of  course  would  be  made 
either  in  the  special-column  journal  or  sales  book  (whichever  is 
used).  The  slips  are  then  filed  by  customers'  names,  and  the 
file  constitutes  the  customers'  ledger.  This  procedure  saves  all 
the  time  required  to  post  from  the  sales  book  to  customers'  ac- 
counts. When  the  customer  pays  his  account  he  is  given  a 
receipt  which  is  also  made  out  in  duplicate.  The  duplicate,  after 
being  used  for  making  the  cash  book  entry,  is  filed  with  the  sales 
slips.  This  makes  the  record  with  each  customer  complete  in  the  file. 

The  same  method  in  principle  is  often  used  by  manufacturers. 
Here  the  invoice  covering  a  sale  of  goods  is  made  out  in  duplicate, 
the  original  being  sent  to  the  customer  as  an  invoice  and  the 
duplicate  retained  for  his  account.  These  duplicate  invoice 
sheets  are  first  used  for  sales  book  entries  and  are  then  filed  alpha- 
betically by  customers'  names.  This  file  constitutes  the  custom- 
ers' ledger.  The  form  of  file  depends  on  the  form  of  invoice.  In 
some  cases  the  invoices  are  prepared  to  fit  a  loose-leaf  binder. 
Again  the  duplicate  might  be  made  on  a  card  of  convenient  size 
for  placing  in  a  card  file.  Even  the  standard  letter  file  might  be 
used,  although  the  looseness  of  such  a  system  makes  possible  a 
great  many  errors  which  would  not  occur  as  frequently  under 
one  of  the  other  methods. 


g8  PRINCIPLES  OF  ACCOUNTING 

Local  public  utilities  such  as  gas,  electric,  water  and  telephone 
companies  which  bill  their  customers  but  once  a  month  often  have 
the  sales  book  arranged  in  such  form  that  it  may  also  be  used  for 
a  customers'  ledger.  The  table  on  page  99  is  an  illustration  of  a 
page  from  such  a  combination  sales  book  and  customers'  ledger 
for  a  gas  company. 

This  book  is  arranged  in  such  a  form  that  considerable  statis- 
tical information  in  addition  to  sales  and  customers'  accounts  is 
available.  In  the  first  place  the  names  of  all  customers  are  ar- 
ranged in  a  convenient  order  usually  according  to  the  meter 
readers'  routes.  This  is  done  so  that  the  index  readings  obtained 
from  the  meter  readers'  book  may  be  copied  in  consecutive  order. 
The  reading  from  the  previous  month  in  each  case  is  set  down  in 
the  first  index  column  and  the  reading  for  the  current  month  is 
placed  in  the  next  column,  and  the  difference  between  these  two 
columns  is  listed  in  the  column  headed  "Amount  Consumed  Cu. 
Ft."  The  total  of  the  amount  consumed  column  shows  the  total 
amount  of  gas  actually  sold.  This  figure  is  of  considerable  impor- 
tance to  the  plant  manager.  A  meter  at  the  plant  registers  the 
total  amount  produced  and  by  comparing  that  figure  with  the 
amount  registered  by  the  customers'  meters,  he  can  determine  the 
amount  lost  and  unaccounted  for.  This  figure  of  course  he  tries 
to  keep  as  low  as  possible. 

The  gross  amount  of  each  bill  is  shown  in  the  next  column. 
This  is  found  by  multiplying  the  rate  by  the  amount  consumed. 
The  discount  allowed  for  prompt  payment  of  the  bill  is  listed  in 
the  following  column.  The  difference  between  the  gross  bill  and 
the  allowed  discount  is  placed  in  the  column  headed  "Net." 
The  total  of  this  column  represents  the  total  net  sales  for  the 
month  and  can  be  used  for  making  the  proper  entries  in  the 
ledger  —  a  debit  to  Accounts  Receivable  and  a  credit  to  Sales. 
This  is  the  extent  to  which  the  book  can  be  used  for  journal  pur- 
poses, the  remaining  columns  being  exclusively  for  ledger  purposes. 

Any  unpaid  balances  from  the  preceding  month  are  carried 
to  the  column  to  the  right  of  the  net  figure.  The  second  customer 
in  the  illustration,  John  B.  Campbell,  failed  to  pay  his  December 
bill  as  shown  by  the  fact  that  $3.10  is  listed  opposite  his  name  in 
the  column  headed  "Brought  forward  from  December."  The 
sum  of  the  figures  in  the  net  and  brought  forward  columns 


DEVELOPMENTS  IN  TECHNIQUE 


99 


Pllfi 


OOOOOOOOOOO 


O 

\O 


M     IOM 


r-»  oo  oo    'o  GO      fo 


CO     M  M 


O    O    ort 
felJHfePM 

'OC1OOOO 


t^-OO      O\O      M      M 


100  PRINCIPLES  OF  ACCOUNTING 

constitutes  the  debit  to  the  customers'  accounts  for  payments 
made  before  the  discount  period  expires.  For  payments  made 
after  this  date  the  gross  bill  is  charged  instead  of  the  net. 

Credits  to  the  customers'  accounts  are  made  in  the  column 
headed  "Paid."  A  space  is  provided  to  show  the  date  and  the 
amount  of  the  payment.  All  payments  made  up  to  January 
1 2th,  the  last  discount  date,  are  made  at  the  net  rate.  If  a  cus- 
tomer fails  to  pay  until  after  that  date,  the  gross  bill  is  paid. 
Richard  Snow,  for  example,  paid  his  bill  on  January  iyth  as 
shown  by  the  entries  in  the  paid  column  on  the  seventh  line  and 
the  amount  corresponds  to  the  gross  charge.  The  general  ledger 
entries  for  cash  receipts  from  customers  are  posted  from  the 
proper  columns  in  the  cash  book.  A  duplicate  receipt  is  retained 
by  the  company  which  is  used  first  for  the  cash  book  entry  and 
then  for  the  customers'  ledger. 

Finally  on  the  last  day  of  the  month  the  amounts  remaining 
unpaid  are  carried  forward  to  the  proper  column  in  the  Feb- 
ruary section.  In  the  illustration  three  such  amounts  are  shown 
on  lines  two,  five  and  ten. 

A  single  line  can  be  used  for  a  customer's  account  throughout 
the  year  by  placing  the  information  for  succeeding  months  in 
adjacent  columns.  This  can  be  accomplished  without  making 
the  book  unduly  large  by  the  use  of  a  system  of  large  and  small 
pages  in  a  single  binder.  The  columns  for  the  customers'  names 
and  addresses  and  for  the  meter  numbers  can  be  placed  on  the 
left-hand  side  of  a  large  page,  then  a  sufficient  number  of  smaller 
pages  can  be  inserted  for  carrying  the  remaining  columns  grouped 
by  months  as  was  shown  for  January  in  the  illustration.  The 
edges  of  the  smaller  sheets  would  then  come  even  with  the  meter 
number  column. 

This  method  of  treating  customers'  accounts  for  public  utili- 
ties has  been  quite  widely  adopted  by  gas,  electric,  water,  and 
telephone  companies  but  it  has  certain  disadvantages  which  have 
prevented  its  being  used  in  many  places.  Its  greatest  labor 
saving  feature  depends  on  the  permanency  of  its  customers. 
The  whole  list  of  names  is  revised  but  once  each  year.  New 
names  are  added  at  the  end  of  the  book  and  whenever  a  meter 
is  removed  for  a  customer  his  line  in  the  ledger  remains  blank  for 
the  rest  of  the  year.  This  is  a  very  important  consideration  in 


DEVELOPMENTS  IN  TECHNIQUE 


101 


what  may  be  called  a  transient  community,  where  a  great  many 
meters  are  being  removed  and  new  ones  set  each  month.  In 
such  cases  it  is  much  simpler  to  maintain  a  separate  ledger  page 
for  each  customer's  account.  The  following  is  a  page  from  the 
customers'  ledger  of  a  gas  company  which  comes  within  this 
class. 


FOR  MONTH 

INDEX 

CONSUMED 

AMOUNT 

NET 

BACK  BILL 

PAID 

DATE 

DISCOUNT 

ENDING 

OOO 

1917 

1917 

Jan. 

24 

24 

2.40 

2.40 

Feb.     5 

Feb. 

89 

65 

5.85 

6.50 

Mar.  24 

-65 

Mar. 

no 

21 

2.IO 

Apr. 

Apr. 

May 

May 

June 

June 

July 

July 

Aug. 

Aug. 

Sept. 

Sept. 

7 

Oct. 

Oct. 

Nov. 

Nov. 

Dec. 

1918 

Dec. 

Jan. 

1918 

Jan. 

Feb. 

For  each  customer  one  of  these  sheets  is  kept  in  a  loose-leaf 
binder.  The  order  of  names  in  the  ledger  follows  the  route  order 
of  the  meter  readers.  As  new  meters  are  set  new  sheets  are  in- 
serted in  the  proper  place  and  as  old  meters  are  removed  the 
customer's  sheet  is  removed  from  the  binder. 

This  form  of  ledger  makes  its  use  for  sales  book  purposes 
somewhat  more  awkward  than  the  preceding  one  but  it  is  used 
for  this  purpose  nevertheless.  As  soon  as  all  bills  have  been 
entered  for  the  month  an  adding  machine  total  of  the  charges 
to  all  customers'  accounts  is  taken.  This  total  is  the  basis  for 
the  debit  to  Accounts  Receivable  and  the  credit  to  Revenue. 
Thus  a  special  sales  book  again  is  unnecessary. 


102  PRINCIPLES  OF  ACCOUNTING 

The  illustrations  given  in  this  chapter  show  the  present  tend- 
ency to  abbreviate  the  accounting  records  and  to  simplify  the 
work  of  the  bookkeeper.  In  every  type  of  business  the  forms  of 
records  are  being  constantly  altered  and  improved  in  various  ways 
to  decrease  the  detail  work  required.  The  illustrations  can  only 
be  suggestive,  however,  since  the  actual  records  found  in  a  given 
case  should  and  do  depend  on  the  type  of  business  and  the 
kinds  of  information  desired.  No  particular  system  of  journal 
and  ledger  forms  could  be  universally  adopted. 


VI 

THE  ASSET  ACCOUNTS 

ACCOUNTS  were  classified  in  Chapters  II  and  III  in  terms  of 
assets  and  equities,  and  the  important  phases,  positive  and  nega- 
tive, of  these  balance  sheet  classes.  This  classification  is  of  fun- 
damental importance  in  that  it  constitutes  the  skeleton  of  any 
system  of  accounts  which  should  always  be  kept  in  mind  in  the 
process  of  analyzing  transactions  into  debit  and  credit  entries. 
Further  division  and  analysis  are  necessary  at  this  stage,  however, 
;.f  the  student  is  to  have  an  adequate  understanding  of  the  nature 
of  the  common  accounts  which  are  used  in  recording  business  data 
and  the  significance  of  the  various  transactions  which  may  affect 
these  accounts.  In  the  present  chapter  the  asset  accounts  will 
be  considered  in  some  detail.  The  nature  and  function  of  each 
of  the  important  sub-groups  will  be  explained  ;  and  typical  oc- 
currences which  give  rise  to  entries  in  these  accounts  will  be  dis- 
cussed. This  discussion  will  serve  to  illustrate  further  the  prin- 
ciples of  journalizing.  Some  consideration  will  also  be  given  to 
the  problem  of  detail  classification  for  managerial  purposes.  In 
Chapter  VII  the  equity  accounts  will  be  further  classified  and 
explained. 

ACCOUNTS    WITH   FIXED    TANGIBLE    ASSETS 

Among  the  assets  perhaps  the  most  important  general  dis- 
tinction is  between  fixed  and  current  items.  Several  references  to 
this  classification  have  already  been  made,  and  in  the  following 
pages  it  will  be  necessary  to  return  to  this  division  repeatedly. 
Fixed  assets,  in  turn,  may  be  divided  into  material  and  immaterial 
—  or  tangible  and  intangible  —  items.  In  this  section  the  im- 
portant types  of  accounts  with  fixed  tangible  a.  sets  will  be  dis- 
cussed. 

103 


104  PRINCIPLES  OF  ACCOUNTING 

In  this  group  may  be  included  all  those  accounts  which  repre- 
sent the  more  permanent  types  of  material  property.  Land, 
buildings,  and  machinery  are  common  examples  of  the  fixed  tan- 
gibles. These  assets  represent  the  durable  equipment  of  the 
enterprise.  This  equipment  is  purchased  to  be  used  in  opera- 
tion, not  to  be  sold.  Usually  a  large  part  of  the  capital  of  an 
enterprise  is  invested  in  such  assets.  For  this  reason,  and  be- 
cause such  items  present  difficult  problems  in  connection  with 
valuations,  the  accounts  with  the  fixed  tangibles  constitute  the 
most  important  group  of  fixed  asset  accounts. 

The  debit  side  of  such  accounts  —  as  is  the  case  with  all  asset 
accounts  —  is  used  in  recording  additions.  These  additions 
should  not  be  thought  of  primarily  in  the  physical  sense.  The 
data  with  which  accounting  deals  are  values,  measured  in  terms 
of  the  money  unit.  Additions  to  these  assets,  then,  mean  value 
additions ;  and  such  increases  in  a  particular  case  may  be  due 
either  to  the  receipt  of  additional  physical  units,  to  the  improve- 
ment of  units  already  owned,  or  to  an  advance  in  prices  which 
alters  the  value  of  units  in  use.  All  possible  situations  which 
give  rise  to  charges  to  these  accounts  may  be  put  under  these 
three  cases. 

Then  debits  to  the  Buildings  account  of  the  A.  B.  Co.,  for  ex- 
ample, may  represent  any  of  the  following  facts  :  (i)  the  original 
purchase  price  or  construction  cost  of  the  buildings  owned  by 
the  enterprise  (or  the  purchase  price  or  construction  cost  of  new 
buildings  or  additions) ;  (2)  the  amount  of  an  improvement ; 
(3)  the  increase  in  the  value  of  the  buildings  due  to  price  changes. 
Cases  (2)  and  (3)  require  brief  explanation.  An  improvement,  in 
the  accounting  sense,'  is  an  increase  in  the  value  of  an  asset  caused 
by  a  change  in  the  physical  structure  of  the  asset.  The  replace- 
ment of  a  shingle  roof  with  a  more  expensive  slate  roof  is  an  il- 
lustration. The  difference  between  the  value  of  the  old  roof  and 
that  of  the  new  is  an  addition  to  the  value  of  the  building,  and 
hence  properly  represents  a  charge  to  the  Buildings  account. 
Increases  in  value  above  cost  which  are  not  due  to  improvements 
are  usually  caused  by  an  advance  in  the  prices  of  labor  and  mate- 
rials either  during  the  period  of  construction  or  after  the  building 
is  finished.  It  should  be  noted,  however,  that  it  is  seldom  neces- 
sary to  make  specific  debit  entries  in  the  Buildings  account  to 


THE  ASSET  ACCOUNTS  105 

cover  such  increases.  With  the  exception  of  land  most  tangible 
fixed  assets  decline  in  value  as  a  result  of  operating  conditions  at 
a  rate  more  than  sufficient  to  offset  any  advance  in  purchase 
prices  or  construction  costs.  The  actual  rate  of  expiration,  never- 
theless, varies  because  of  these  price  changes ;  and  if  such  a  vari- 
ation is  taken  into  consideration  in  accounting  for  value  declines 
this  virtually  means  the  recognition,  in  the  accounts,  of  price 
advances. 

The  policy  of  recognizing  all  value  increases  —  from  whatever 
source  —  as  proper  matters  for  accounting  record  assumes  that 
it  is  the  function  of  the  property  accounts  to  show  continuously 
the  actual  value  of  the  equipment  owned  in  any  case.  The 
legitimacy  of  such  an  assumption  cannot  be  conveniently  dis- 
cussed at  this  point.  This  and  other  fundamental  problems  of 
valuation  will  be  carefully  considered  in  Chapter  XX.  For  the 
present  it  will  be  taken  for  granted  that  every  asset  account  should 
show  present  values  as  far  as  possible. 

Entries  in  the  credit  side  of  these  accounts  represent  subtrac- 
tions. These  subtractions  may  indicate  either  of  two  distinct 
happenings  :  (i)  a  credit  entry  may  represent  the  sale  or  disposal 
of  a  specific  unit  or  units  of  an  asset ;  or  (2)  a  credit  may  repre- 
sent the  value  expiration  of  units  still  in  use  as  a  result  of  business 
operation  and  unfavorable  price  changes.  In  the  case  of  a  suc- 
cessful enterprise  there  is  a  sense  in  which  the  expiration  of  an 
asset  due  to  the  conditions  of  operation  may  be  conceived  as  the 
sale  of  an  asset,  or  the  exchange  of  one  asset  for  another ;  for 
certainly  the  equipment  which  is  consumed  in  the  process  of 
production  is  normally  replaced  from  the  proceeds  of  the  sale  of 
product.  But,  as  was  stated  in  Chapter  III,  entries  covering 
the  expirations  of  assets  cannot  conveniently  be  made  concur- 
rently with  the  entries  recording  the  additions  to  assets  resulting 
from  the  sales  of  finished  goods.  Hence,  as  an  important  ac- 
counting consideration,  the  distinction  between  the  two  types  of 
subtractions  from  assets  should  be  emphasized. 

Then  credits  to  Buildings,  for  example,  may  represent  either  of 
the  following  facts  :  (i)  the  selling  price  of  a  new  or  second-hand 
building  or  buildings ;  (2)  the  amount  of  the  value  expiration  of 
a  building  or  buildings  during  a  given  period  (normal  or  abnormal 
depreciation).  Each  of  these  cases  will  be  briefly  discussed. 


io6  PRINCIPLES  OF  ACCOUNTING 

Since  an  enterprise  seldom  sells  all  or  any  part  of  its  fixed  equip- 
ment credits  representing  case  (i)  are  of  very  infrequent  occur- 
rence. When  a  particular  building  or  other  asset  is  scrapped, 
however,  it  commonly  has  some  small  salvage  value,  and  the 
entry  covering  this  amount  represents,  in  a  sense,  the  sale  or  dis- 
posal of  a  fixed  asset.  Other  transfers  also  occasionally  occur. 
A  firm,  for  example,  which  owns  several  buildings  and  sites,  may 
find  it  desirable  to  sell  a  parcel  of  its  real  estate  even  when  the 
unit  sold  is  in  good  physical  condition. 

The  second  case  of  subtractions  mentioned  above  is  of  much 
more  common  occurrence.  As  already  explained,  most  of  the 
items  which  make  up  a  firm's  fixed  equipment  are  continuously 
depreciating.  With  the  possible  exception  of  land  a  " fixed" 
asset  is  not  usually  a  permanent  asset.  The  managements  of 
business  enterprises  have  sometimes  ignored  this  obvious  fact 
to  their  sorrow.  Wear  and  tear  from  use  and  the  action  of  the 
elements,  or  deterioration,  is  the  most  universal,  and  perhaps  the 
most  important,  cause  of  depreciation.  Obsolescence,  or  value 
decline  due  to  the  fact  that  a  certain  type  of  equipment  has  been 
rendered  out  of  date  by  new  inventions  and  improvements,  is 
another  important  cause  of  depreciation  —  in  some  cases  the 
most  significant.  Price  changes  which  lower  purchase  prices 
and  construction  costs,  and  general  economic  changes  which 
render  specific  types  of  equipment  inadequate  for  the  purposes 
for  which  they  were  intended  (such  as  a  change  in  the  character 
of  railway  traffic  which  compels  a  railroad  company  to  substitute 
box  cars  for  flats),  are  also  factors  responsible  for  large  amounts 
of  depreciation.1 

It  is  the  prevailing  practice  to  use  valuation  accounts  to  show 
all  subtractions  from  fixed  assets  which  represent  depreciation. 
These  expirations  are  recognized  only  at  intervals  and  are  credited 
to  valuation  accounts,  as  explained  in  Chapter  III,  instead  of 
being  credited  directly  to  the  asset  accounts.  One  reason  for 
the  use  of  these  subsidiary  accounts  is  the  desire  on  the  part  of 
the  management  in  any  case  to  preserve  original  cost  figures  in 
the  asset  accounts.  Further,  it  is  sometimes  urged  that  since 

1  No  attempt  will  be  made  at  this  point  to  discuss  the  difficult  problems* of 
depreciation  accounting.  Chapters  XXII  and  XXIII  are  devoted  primarily  to 
this  topic. 


THE   ASSET  ACCOUNTS  107 

the  amount  of  the  value  expiration  of  a  fixed  asset  which  occurs 
in  a  given  period  is  merely  an  estimate  it  is  desirable  to  set  up  the 
estimated  figure  in  a  separate  account.  It  is  doubtful  if 
either  of  these  considerations  deserves  the  stress  that  has  been 
laid  upon  them  by  accountants,  although  they  are  matters  of 
some  importance.  Cost  figures  are  not  always  of  great  signifi- 
cance ;  and  in  any  case  they  can  be  determined  from  the  books 
of  original  entry.  And  the  mere  fact  that  a  figure  is  an  estimate 
is  hardly  sufficient  reason  for  setting  it  up  in  a  special  account. 
It  is  a  fact  sometimes  overlooked  that  accounting  deals,  to  an 
important  extent,  with  estimates  rather  than  certainties.  Never- 
theless the  use  of  valuation  accounts  in  this  connection  is  entirely 
rational ;  and  it  is  a  practice  which  is  likely  to  persist. 

It  is  unfortunate  that  these  valuation  accounts  are  usually 
called  ''reserves."  The  term  reserve  suggests  surplus,  and  is 
actually  applied  in  practice  to  special  surplus  accounts.  This 
nomenclature  undoubtedly  leads  to  considerable  confusion  in 
interpreting  these  accounts  —  even  among  those  with  some 
knowledge  of  accounting  technique.  The  point  should  be 
emphasized  here  that  these  accounts  are  in  no  sense  a  part 
of  any  of  the  proprietary  or  other  equity  accounts.  They 
belong  rather  to  the  fixed  asset  accounts.  Each  valuation  ac- 
count must  be  read  in  connection  with  the  corresponding  asset 
account.  If,  for  example,  the  Buildings  account  of  a  certain 
enterprise  shows  a  debit  balance  of  $10,000  and  "Reserve  for 
Depreciation  of  Buildings"  shows  a  credit  balance  of  $2,000, 
this  means  that  the  estimated  value  of  the  asset,  buildings,  is 
the  difference  between  these  two  amounts,  or  $8,000.  The 
two  accounts,  taken  together,  show  the  status  of  the  asset. 
The  term  allowance,  as  already  suggested,  is  a  more  suitable 
designation  than  reserve  for  the  valuation  account;  and  this 
expression,  for  the  sake  of  clearness,  will  be  used  throughout  the 
text. 

To  sum  up,  then,  it  appears  that  entries  in  the  main  accounts 
with  tangible  fixed  assets  are  not  of  very  frequent  occurrence. 
The  original  costs  and  the  amount  of  all  improvements  are 
charged  to  the  property  accounts,  and  all  sales  are  credited  to 
these  accounts.  All  expirations,  however,  are  usually  credited 
to  valuation  accounts.  Occasionally  increases  in  value  due  to 


io8  PRINCIPLES  OF  ACCOUNTING 

price  changes  more  than  offset  the  expirations  and  must  be  taken 
into  consideration. 

The  following  transactions  illustrate  the  important  cases  dis- 
cussed above : 

1.  The  A.  B.  Co.  has  contracted  for  an  addition  to  its  plant 
to  cost  $10,000.     The  work  is  finished  and  the  contract  price  is 
paid  in  cash.     The  journal  entries  for  this  transaction  (in  sum- 
mary form)  would  be  as  follows : 

Buildings $10,000 

Cash $10,000 

The  entries  covering  the  purchase  of  an  important  unit  of  prop- 
erty would  usually  be  much  more  detailed  than  the  above.  If 
the  A.  B.  Co.  constructed  the  addition  itself  a  set  of  construction 
accounts  would  be  needed.  If  the  work  were  done  by  an  outside 
firm  payment  would  usually  be  made  in  installments.  The 
entries  given,  however,  show  the  final  effect  of  the  transaction 
upon  the  Buildings  account. 

2.  The  past  year  has  seen  a  considerable  growth  in  the  popu- 
lation of  the  city,  and  as  a  result  land  in  certain  districts  has  risen 
in  value.      The  value  of  the  A.  B.  Co.'s  site  has  appreciated 
$2,000.     This  situation  would  be  recognized  in  the  accounts  by 
the  following  entries : 

Land $2,000 1 

Surplus $2,000 

The  increase  in  land  value  recorded  by  these  entries  means  a  net 
increase  in  proprietorship  since  no  expirations  whatever  are 
involved.  Consequently  the  increase  in  ownership  can  be  cred- 
ited directly  to  Surplus.  Since  the  increase  has  occurred  during 
the  year  it  might  be  considered  proper  to  credit  the  Net  Revenue 
account  with  the  amount.  Such  an  item  is  not,  however,  a  net 
revenue  from  operation  in  the  strict  sense;  and  in  general  it 
is  desirable  to  use  the  Surplus  account  to  reflect  all  speculative 
changes  in  the  equities.  The  problem  of  appreciation  and  the 

1  This  increase  has  no  doubt  occurred  gradually  during  the  accounting  period. 
The  charge  to  Land,  then,  can  be  conceived  as  a  summary  of  a  large  number  of 
small  changes. 


THE  ASSET  ACCOUNTS  109 

entries  which  should  be  made  to  show  such  value  changes  in  the 
accounts  will  receive  careful  consideration  later  in  the  text. 

3.  It  is  estimated  that  the  depreciation  of  the  buildings  of  the 
A.  B.  Co.  for  one  month  amounts  to  $125.     This  transaction 
represents  a  subtraction  from  a  fixed  asset  of  $125  and  an  equal 
charge  to  Expense.1    The  entries  would  be : 

Expense    .     .     < $125 

Buildings $125 

Or,  if  a  valuation  account  were  used,  the  transaction  would  be 
journalized  as  follows: 

Expense $125 

Allowance  for  Depreciation  of  Buildings  $125 

It  is  important  that  the  student  grasp  the  exact  nature  of  this 
variation  in  the  entries  which  represent  such  a  situation.  The 
charge  to  Expense  is  the  same  in  each  case ;  but  in  the  second 
pair  of  entries  a  credit  to  a  valuation  account  is  substituted  for 
a  credit  to  Buildings.  The  significance  of  the  credit  entry,  how- 
ever, must  be  the  same  in  both  cases ;  in  either  instance  it  rep- 
resents a  subtraction  from  the  value  of  the  buildings. 

4.  A  building  of  the  A.  B.  Co.  which  has  become  unfit  for 
further  use  is  sold  to  a  wrecking  company  for  $3,000.     The  cost 
of  this  unit,  it  will  be  assumed,  was  $15,000.     If  depreciation 
has  been  correctly  accounted  for  the  Allowance  for  Depreciation 
of  Buildings  account  should  show  at  this  time  credits  amounting 
to  $12,000  applicable  to  this  unit.     Such  accuracy  in  estimating 
depreciation  is,  of  course,  very  unlikely ;   but  to  simplify  the  il- 
lustration it  will  be  assumed  in  this  case  that  there  have  been 
credits  to  the  valuation  account  for  the  exact  amount  of  deprecia- 
tion.    The  entries  representing  the  sale  of  the  old  building  would 
then  be  as  follows  : 

Cash $  3,000 

Allowance  for  Depreciation  of  Buildings      12,000 

Buildings $15,000 

1  A  special  expense  account  might  well  be  used  here.    The  classification  of 
expense  accounts  will  be  discussed  in  the  next  chapter. 


HO  PRINCIPLES  OF  ACCOUNTING 

The  only  actual  happening  here  is  the  exchange  of  a  building 
worth  $3,000  for  an  equal  amount  of  cash.  Since  the  property 
unit  is  entirely  discarded,  however,  there  is  clearly  no  object  in 
longer  maintaining  additions  and  subtractions  in  separate  ac- 
counts. Accordingly  the  two  accounts,  Buildings  and  its  sub- 
sidiary, are  balanced  as  far  as  this  particular  unit  of  property  is 
concerned. 

Transactions  affecting  the  accounts  with  tangible  fixed  assets 
will,  of  course,  differ  very  widely  in  practice  as  regards  the  con- 
crete circumstances  involved.  The  cases  discussed  and  journal- 
ized here,  however,  represent  the  principal  types  of  occurrences 
which  require  recognition  in  these  accounts.  The  student  should 
now  be  able  to  analyze  any  possible  transaction  involving  fixed 
tangibles  as  far  as  its  effect  upon  the  asset  accounts  is  concerned. 
The  classification  of  the  equipment  accounts  for  managerial  pur- 
poses will  be  discussed  in  a  later  section  of  this  chapter. 


ACCOUNTS   WITH   FIXED   INTANGIBLES 

a.  First  will  be  considered  under  this  head  the  group  which 
includes  any  account  with  a  right  against  —  or  an  equity  in  — 
the  assets  of  an  individual  or  enterprise  other  than  the  firm  on 
whose  books  such  account  appears.  Rights  which  may  be  said 
to  constitute  fixed  assets  are  commonly  represented  by  such  in- 
struments as  long-term  notes,  mortgages,  bonds,  stocks  and 
other  securities.  Obviously  such  assets,  in  themselves,  are  im- 
material items,  since  they  exist  as  rights  rather  than  as  tangible 
objects ;  but  a  right  may  consist  in  a  lien  upon  specific  tangible 
assets.  A  mortgage,  or  a  bond  based  upon  a  mortgage,  for  ex- 
ample, usually  represents  a  lien  upon  some  part  or  all  of  the  tan- 
gible equipment  of  an  enterprise.  A  promissory  note,  on  the  other 
hand,  ordinarily  represents  a  claim  against  an  enterprise  itself 
—  or  a  general  claim  against  the  assets  of  the  enterprise  —  rather 
than  a  lien  upon  specific  assets.  A  share  of  stock  is  an  evidence 
of  a  right  of  ownership  in  an  incorporated  enterprise  rather  than 
a  right  to  particular  assets;  but  such  a  security,  nevertheless, 
also  represents  a  residual  general  equity  in  the  assets  of  the  enter- 
prise, as  was  noted  in  Chapter  II. 


THE  ASSET  ACCOUNTS  in 

In  this  connection  the  distinction  between  a  right  as  an  asset 
and  the  same  right  as  an  equity  should  be  emphasized.  A  right 
in  a  specific  enterprise,  from  the  standpoint  of  that  enterprise, 
is  an  equity,  and  would  appear  in  the  accounts  as  such.  From 
the  standpoint  of  the  individual  or  firm  possessing  the  right,  the 
item  is  an  asset  —  provided,  of  course,  that  the  equity  in  question 
has  any  value.  In  other  words,  rights  appear  in  accounting 
records  under  duplicate  heads  —  equities  in  one  case,  assets  in 
the  other.  This  duplication  is,  evidently,  not  possible  in  the  case 
of  tangible  assets.  In  interpreting  transactions  involving  rights, 
therefore,  it  is  necessary  to  keep  definitely  in  mind  the  particular 
enterprise  whose  accounts  are  affected  by  these  transactions. 

As  regards  length  of  life  —  or  the  time  the  asset  remains  in 
the  business  —  long-term  securities  are  often  as  "fixed"  in  char- 
acter as  buildings  and  machinery.  Nevertheless  there  is  another 
line  of  distinction  between  fixed  and  current  assets  which  should 
be  considered.  A  current  asset  might  be  defined  as  any  asset 
which  can  readily  be  converted  into  cash  or  an  equivalent.  A  fixed 
asset  would,  accordingly,  be  an  asset  which  could  not  be  easily 
liquidated  for  its  full  value.  From  this  standpoint  securities  and 
similar  rights  may  be  considered  current  assets ;  for  usually  all 
such  rights  can  be  converted  into  cash  with  comparative  ease. 
A  classification  of  assets  into  fixed  and  current  items  on  this 
basis  is  a  matter  of  practical  importance  in  cases  where  the  pur- 
pose of  the  classification  is  the  determination  of  the  immediate 
financial  condition  of  the  enterprise. 

Length  of  life,  as  well  as  liquidity,  however,  is  an  important 
general  consideration  to  be  observed  in  classifying  assets.  In  the 
case  of  an  asset  used  in  operation  length  of  life  is  roughly  ex- 
pressed in  the  accounts  by  the  rate  with  which  the  item  is  trans- 
ferred from  an  asset  account  to  an  expense  account.  Then  a 
current  asset,  from  this  standpoint,  is  an  asset  which  passes  quickly 
into  the  expense  category.  A  fixed  asset  is,  therefore,  an  item 
which  remains  an  asset,  in  large  measure,  for  a  comparatively 
long  interval.  According  to  this  definition  a  security  which  is 
held  for  investment  is  a  fixed  asset.  But  many  rights  never  give 
rise  to  expense  charges.  A  contractual  right  such  as  that  rep- 
resented by  a  mortgage  may  remain  of  practically  constant  value 
—  aside  from  interest  accruals  —  throughout  its  life.  At  matu- 


H2  PRINCIPLES  OF  ACCOUNTING 

rity  the  contractual  sum  is  paid.  This  is  true  of  short-term  as 
well  as  long-term  securities.  On  the  other  hand  a  right  such  as 
an  annuity,  which  consists  in  a  series  of  payments  which  include 
both  principal  and  interest,  expires  as  the  payments  are  made, 
and  the  amount  of  the  expiration  in  each  case  constitutes  a  sub- 
traction from  the  value  of  the  annuity  and  a  subtraction  from  the 
gross  revenue  received.1  It  is  evident  that  the  classification  of 
rights  as  fixed  and  current  assets  is  a  matter  of  particular  diffi- 
culty. 

Whichever  basis  for  distinguishing  between  fixed  and  current 
assets  be  adopted  there  is  no  hard  and  fast  principle  to  be  fol- 
lowed which  covers  all  cases.  As  regards  length  of  life  an  asset 
such  as  a  stock  of  postage  stamps,  for  example,  which  will  be 
consumed  in  a  few  days,  is  clearly  a  current  asset ;  and  a  fire- 
proof building,  which  will  probably  remain  in  a  particular  busi- 
ness for  many  years  (and  may  be  a  valuable  object  for  a  century 
or  more),  is  obviously  a  fixed  asset.  On  the  other  hand  a  promis- 
sory note  running,  it  may  be  assumed,  for  three  years,  might, 
with  reason,  be  classed  in  either  group.  Similarly,  in  respect 
to  liquidity,  the  assets  of  the  typical  enterprise  vary  from  cash 
itself  to  assets  which  can  scarcely  be  converted  into  cash  except 
through  the  process  of  production ;  but  the  point  in  the  series 
which  divides  the  current  assets  from  the  fixed  is  usually  difficult 
of  exact  determination. 

In  some  cases  rights  represent  the  large  part  of  a  firm's  capital. 
Banking,  insurance  and  trust  companies  are  examples  of  such 
enterprises.  In  such  cases  the  accounts  representing  rights  form 
a  very  important  part  of  the  accounting  structure.  These  ac- 
counts may  be  subdivided  for  statistical  purposes  almost  indefi- 
nitely. An  insurance  company,  for  example,  may  find  it  de- 
sirable to  keep  subsidiary  accounts  for  each  distinct  security  issue 
which  it  owns  as  well  as  controlling  accounts  with  the  principal 
types  of  securities  and  other  rights  in  its  possession.  In  the  case 
of  underwriting  companies  and  brokerage  houses  securities  are 

1  A  share  of  stock  in  a  wasting  enterprise  such  as  a  mine  represents  a  sort  of 
indefinite  annuity,  and  is  therefore  normally  a  depreciable  asset.  Any  right,  of 
course,  may  expire  either  because  of  changes  in  the  circumstances  of  the  enterprise 
in  which  the  right  is  an  equity,  or  because  of  general  changes  in  the  market  for  such 
securities.  Transactions  involving  the  valuation  of  annuities  and  other  securities 
will  be  considered  in  detail  in  Part  Three. 


THE  ASSET  ACCOUNTS  113 

usually  purchased  only  to  be  sold  again.  Rights  constitute  the 
merchandise  of  such  a  concern,  and  the  security  accounts  are 
analogous  to  the  merchandise  accounts  of  a  retail  enterprise. 
Evidently  the  assets  handled  in  such  a  case  are  current  rather 
than  fixed.  Banking  and  insurance  companies,  however,  com- 
monly hold  large  amounts  of  securities  and  similar  rights  as  in- 
vestment indefinitely,  or  until  the  specific  contracts  or  securities 
terminate.  This  illustrates  the  fact  that  the  distinction  between 
fixed  and  current  assets  depends  not  merely  on  the  nature  of  the 
asset  itself  in  any  case  but  upon  the  character  of  the  enterprise 
possessing  such  asset  as  well. 

Further,  almost  every  large  corporation  owns  securities  and 
rights  in  other  organizations  and  enterprises  which  it  holds  for 
investment  and  other  purposes.  Such  holdings  are  probably 
becoming  more  rather  than  less  common.  Recent  purchases  of 
government  bonds  on  a  large  scale  by  "industrial"  as  well  as 
investment  companies  illustrate  this  tendency. 

Debit  entries  in  accounts  with  long-term  rights  cover,  in  gen- 
eral, the  same  possibilities  as  do  charges  to  the  accounts  repre- 
senting the  tangible  equipment.  A  debit  item  may  represent 
the  original  cost  or  value  of  the  asset.  This  original  figure  usually 
expresses  the  market  price  of  the  right  at  the  time  it  was  secured. 
Further,  a  debit  entry  may  represent  an  increase  in  value  above 
the  original  figure. 

Credit  entries  in  these  accounts  may  represent  either  of  two 
types  of  occurrences:  (i)  the  sale  of  specific  units;  or  (2)  the 
decline  in  value  of  units  remaining  on  hand.  These  declines 
represent  either  the  regular  expiration  of  assets  such  as  annuities, 
or  a  fall  in  market  prices  due  to  changes  in  the  interest  rate 
or  other  factors.  It  is  obvious  that  no  depreciation  because 
of  deterioration,  obsolescence  or  inadequacy  is  possible  in  the 
case  of  rights,  for  such  assets  do  not  consist  in  material  objects. 
Hence  the  problems  of  valuation  arising  in  connection  with 
rights  are  in  general  less  complex  than  in  the  case  of  the  fixed 
tangibles. 

The  Bonds  account  of  an  insurance  company,  for  example, 
would  therefore  be  charged  with  the  cost  or  value  of  all  bonds 
secured,  and  with  all  appreciations.  This  account  would  be 
credited  with  the  amounts  received  from  sales  of  bonds  or  amounts 


114  PRINCIPLES  OF  ACCOUNTING 

realized  at  maturity  dates  and  with  all  declines  in  value.1  The 
following  transactions  illustrate  these  cases : 

1.  The  company  buys  U.  S.  4's  to  the  amount  of  $50,000. 
The  entries  would  be  as  follows : 

Bonds       $50,000 

Cash $50,000 

2.  An  inventory  discloses  the  fact  that  certain  bonds  have 
appreciated  in  value,  $8,000.     The  journal  entries  would  be  : 

Bonds $8,000 

Surplus $8,000 

The  credit  in  this  case  might  be  to  the  Net  Revenue  account  (as 
suggested  above  in  the  case  of  land  appreciation),  or  even  to 
Revenue,  provided  such  appreciations  were  a  regular  source  of  in- 
come to  the  company.  The  recognition  of  such  value  changes 
assumes  that  it  is  the  function  of  these  " right"  accounts  —  as 
well  as  the  accounts  with  tangible  assets — to  show  present  values 
whenever  this  is  practicable. 

3.  Bonds  (Harrison  Railway  5%  due  1925)  are  sold  on  the 
market  for  $62,000.     The  entries  would  be : 

Cash $62,000 

Bonds $62,000 

These  entries  assume  that  the  bonds  were  sold  at  a  price  to  yield 
the  book  value.  If  a  gain  were  realized  on  this  sale  the  amount 
of  the  gain  should  be  a  credit  to  Surplus  as  in  the  preceding  case 
instead  of  a  credit  to  Bonds;  but  the  concurrent  debit  entry 
would  be  to  Cash  rather  than  to  the  Bonds  account  since  the  gain 
is  realized  in  cash  in  this  case. 

4.  It  is  discovered  that  bonds  owned  by  the  company  have 
fallen  in  value,  $5,000.     This  transaction  would  be  journalized 
as  follows : 

Surplus $5,ooo 

Bonds $5,ooo 

1  Transactions  involving  accumulation  of  discount  or  amortization  of  premium 
also  affect  bond  values.  These  transactions  and  other  occurrences  involving  ques- 
tions of  principal  and  interest  will  be  discussed  in  Part  Three. 


THE  ASSET  ACCOUNTS  115 

A  firm  that  buys  and  sells  bonds  as  merchandise  would  find  it 
convenient  to  use  at  least  three  bond  accounts.  One  of  these 
accounts  would  show  purchases,  another  sales  and  a  third  would 
represent  inventories.  By  combining  these  accounts  *  the  amount 
of  net  revenue  or  net  loss  for  a  given  period  could  be  ascertained. 
Such  accounts  are  exactly  analogous  to  the  merchandise  accounts 
which  will  be  explained  in  Chapter  VIII.  In  the  entries  shown 
above,  all  variations  in  the  value  of  the  insurance  company's 
bonds  are  credited  or  charged  to  Surplus  as  the  case  may  be,  for 
it  is  assumed  that  these  assets  are  held  for  investment  purposes 
and  that  variations  in  their  value  are  outside  of  the  regular  ex- 
pense and  revenue  accounts  of  the  enterprise. 

It  should  be  recognized  that  the  transactions  considered  above 
are  merely  suggestive  of  the  important  types  of  occurrences  af- 
fecting accounts  with  long-term  securities.  Enterprises  whose 
assets  consist  largely  in  rights  require  intricate  systems  of  ac- 
counts ;  and  the  construction  and  analysis  of  such,  systems  con- 
stitute a  special  branch  of  accounting  of  considerable  importance. 
In  this  text  it  will  not  be  convenient  to  discuss  the  details  of  such 
special  systems ;  but  some  further  consideration  will  be  given 
in  later  chapters  to  transactions  involving  security  valuations. 

b.  Special  mention  should  be  made  of  those  accounts  which 
represent  long-term  rights  to  services  rather  than  rights  to  liquid 
assets  as  income  or  principal.  The  right  to  protection  from  fire- 
loss  for  a  period  of  three  years,  represented  by  an  insurance  pre- 
mium, might  be  considered  a  fixed  immaterial  asset  on  the  books 
of  the  company  making  the  payment.  A  warehouse  lease  run- 
ning for  ten  years,  payment  ($5,000)  made  in  advance,  furnishes 
a  better  example.  The  amount  of  the  payment  would  be  a 
charge  to  a  fixed  asset  account,  thus : 

Lease        $5,ooo 

Cash $S,ooo 

The  asset  in  this  case  consists  in  the  right  to  use  a  certain  other 
asset  for  a  ten-year  period.  Any  payment  which  a  firm  makes 
for  services  which  will  be  furnished  over  a  considerable  period 
represents  a  similar  asset. 

Transactions  giving  rise  to  such  rights  are  of  fairly  common, 
occurrence  in  business  practice.     The  term  "  deferred  charge  " 

1  All  other  expense  and  revenue  items  would,  of  course,  be  included  in  the 
computation. 


Ii6  PRINCIPLES  OF  ACCOUNTING 

is  often  applied  to  such  cases.  An  account  which  represents 
such  an  asset  should  be  debited  with  the  original  cost  or  value  of 
the  service,  and  credited  each  period  with  the  amount  of  the 
expiration  of  the  asset  due  to  the  partial  utilization  of  the  service. 
In  the  case  of  the  lease  mentioned  above,  for  example,  the  follow- 
ing entries  (assuming  one-tenth  of  the  asset  expires  in  each 
period)  would  be  made  every  year : 

Expense  $500 

Lease $500 

Usually  significant  changes  do  not  occur  in  the  values  of  such 
rights,  outside  of  the  expiration  which  represents  the  consumption 
of  the  service  involved  in  any  case.  Assets  of  this  character 
may  be  bought  and  sold,  however,  at  prices  other  than  cost, 
and  even  outside  of  purchase  and  sale  transactions  value  changes 
are  possible.  Troublesome  accounting  problems  often  arise  in 
connection  with  such  assets,  and  some  special  cases  will  be  dis- 
cussed later  in  the  text. 

c.  A  final  group  of  fixed  asset  accounts  embraces  all  those 
accounts  which  represent  the  values  of  privileges  conferred  by 
governments  —  copyrights,  patents,  franchises,  etc.  -  and  the 
value  of  public  opinion  (and  other  advantages)  peculiar  to  the 
individual  concern  —  goodwill.  These  intangibles  are  more 
general  in  character  than  are  the  other  rights  discussed  in  this 
section.  Sometimes  the  term  "intangible"  is  restricted  to  such 
assets.1  Patents  and  franchises  have  a  definite  legal  nature, 
but  the  values  of  the  assets  to  which  they  give  rise  usually  bear 
little  relation  to  the  cost  of  procuring  the  right  in  any  case.  In 
general  these  rights  have  no  competitive  market  value  at  the 
time  the  original  privilege  is  extended.  Goodwill  is  particularly 
general  in  character  and  is  applicable  not  to  specific  tangible 
objects  or  definite  contractual  rights  but  rather  to  the  property 
of  an  enterprise  as  a  whole.  Such  assets  may  be  bought  and 
sold,  however,  and  hence  may  require  exact  accounting  treatment. 
But  since  transactions  involving  such  items  are  rather  unusual, 
and  since  the  problems  of  analysis  which  arise  in  such  cases  are 

1  As  already  stated  the  terms  tangible  and  intangible  are  used  in  this  text  in  the 
sense  of  material  and  immaterial. 


THE  ASSET  ACCOUNTS  117 

particularly  difficult,  further  discussion  of  this  group  of  asset 
accounts  will  be  postponed  for  the  present.  Chapter  XXIV  is 
devoted  to  a  consideration  of  the  nature  and  accounting  treat- 
ment of  these  and  similar  intangibles. 


FUNCTIONAL  CLASSIFICATION   OF   FIXED  ASSET  ACCOUNTS 

In  the  case  of  large  and  complex  enterprises  a.  functional  classi- 
fication of  the  accounts  which  represent  the  fixed  assets  of  the 
business  is  of  great  practical  importance.  For  managerial  pur- 
poses the  fixed  investment  applicable  to  each  department  or 
phase  of  the  enterprise  should  be  segregated  in  the  accounts  as 
far  as  possible.  Only  by  means  of  such  classifications  can  the 
management  secure  from  the  accounting  records  the  data  needed 
in  making  comparisons  for  the  purpose  of  determining  the  relative 
efficiency  of  specific  plants,  departments,  processes,  etc.  In  this 
connection  the  functional  classification  of  expense  accounts  (see 
the  next  chapter)  is  of  even  greater  importance;  but  such  a 
classification  in  any  case  is  facilitated  by  a  corresponding  division 
of  the  asset  accounts.  No  attempt  will  be  made  at  this  point  to 
discuss  in  detail  any  of  the  special  systems  of  asset  accounts 
required  for  particular  types  of  enterprises.1  The  student  is 
better  qualified  to  consider  this  subject  after  the  completion  of  a 
survey  of  the  general  field  of  accounting  principles.  It  is  im- 
portant, however,  that  the  point  of  view  involved  in  this  very 
significant  matter  should  be  suggested  at  this  stage. 

A  simple  classification  of  the  fixed  asset  accounts  of  an  enter- 
prise conforms  to  the  important  departments  or  phases  of  the 
business.  In  a  manufacturing  establishment,  for  example,  there 
are  the  assets  devoted  to  manufacture  or  production  in  the  narrow 
sense,  the  assets  comprising  the  selling  equipment,  and  the  assets 
utilized  for  general  or  administrative  purposes.  The  fellowing 
outline  of  accounts  illustrates  such  a  classification : 

1  Part  Six  of  the  text  is  devoted  largely  to  a  discussion  of  special  systems  of 
accounts  for  manufacturing,  railroad  and  municipal  enterprises.  ' 


n8  PRINCIPLES  OF  ACCOUNTING 

MANUFACTURING 

Factory  Site ; 
f  Factory  Building ; 

I  Allowance  for  Depreciation  of  Factory  Building ; l 
f  Factory  Equipment ;  •••« 

\  Allowance  for  Depreciation  of  Factory  Equipment ; 

Materials  Warehouse  Site ; 
J  Materials  Warehouse ; 

\  Allowance  for  Depreciation  of  Materials  Warehouse ; 
f  Transportation  Equipment ; 
1  Allowance  for  Depreciation  of  Transportation  Equipment. 

SELLING 

Finished  Goods  Warehouse  Site ; 
f  Finished  Goods  Warehouse ; 

\  Allowance  for  Depreciation  of  Finished  Goods  Warehouse ; 
f  Branch  Store  Building; 

1  Allowance  for  Depreciation  of  Branch  Store  Building ; 
f  Transportation  Equipment ; 

I  Allowance  for  Depreciation  of  Transportation  Equipment ; 
f  Other  Selling  Equipment ; 
I  Allowance  for  Depreciation  of  Other  Selling  Equipment. 

ADMINISTRATIVE 
Office  Site ; 
f  Office  Building ; 

\  Allowance  for  Depreciation  of  Office  Building ; 
/  Office  Equipment ; 
\  Allowance  for  Depreciation  of  Office  Equipment. 

In  the  case  of  a  large  scale  enterprise  the  asset  accounts  would 
normally  be  subdivided  for  statistical  purposes  much  further 
than  as  shown  in  the  above  outline.  Not  only  would  each  dis- 
tinct plant  require  a  special  group  of  fixed  asset  accounts  but 
subsidiary  accounts  under  each  main  head  might  be  opened. 
The  account,  Transportation  Equipment,  for  example,  might 
control  several  subsidiary  accounts  such  as  Trucks,  Horses, 
Wagons,  etc.  The  scheme  of  using  subsidiary  and  controlling 
accounts  for  the  fixed  assets  may  be  carried  very  far  in  a  par- 
ticular case.  The  detail  accounts  may  be  collected  in  special 
asset  ledgers,  and  a  controlling  account  for  each  subsidiary  ledger 
may  be  opened  in  the  general  ledger.  Or  the  accounts  in  the 

1  The  relation  between  a  valuation  account  and  the  corresponding  main  asset 
account  js  indicated  by  a  brace  in  each  case. 


THE  ASSET  ACCOUNTS  119 

general  ledger  may  control  in  each  case  one  or  more  accounts  in 
each  of  the  special  ledgers.  In  the  above  outline,  for  example, 
all  of  the  accounts  mentioned  could  evidently  be  classed  under 
the  three  general  accounts,  Land,  Buildings,  and  Equipment, 
and  the  corresponding  valuation  accounts.  In  railroad  account- 
ing the  "Classification  of  Investment  in  Road  and  Equipment" 
prescribed  by  the  Interstate  Commerce  Commission  is  divided 
into  three  "general"  and  seventy-seven  "primary"  accounts. 
(See  Chapter  XXXI.) 

It  should  be  noted  that  the  division  of  asset  and  other  accounts 
in  special  books  according  to  phases  and  departments  of  the 
business  is  desirable  not  only  in  that  it  makes  it  possible  for  the 
manager  (or  anyone  interested)  to  derive  much  more  information 
of  importance  from  the  accounts,  but  also  in  that  it  permits  of 
specialization  on  the  part  of  the  clerical  force  working  on  the 
books.  This  is  a  practical  necessity  in  cases  where  a  large  staff 
of  bookkeepers  and  similar  help  is  employed. 

In  functional  classification  —  as  in  all  other  divisions  —  cer- 
tain cases  arise  in  which  it  is«difficult  to  assign  the  assets  to  par- 
ticular groups  of  accounts  on  a  rational  basis.  For  example, 
the  same  transportation  equipment  may  be  used  to  haul  both 
raw  materials  and  finished  goods.  In  such  a  case  it  is  not  easy 
to  apportion  the  value  of  this  equipment  —  on  any  but  an  ar- 
bitrary basis  —  between  the  manufacturing  and  selling  depart- 
ments. But  in  large  scale  enterprises  —  where  the  equipment 
is  highly  specialized  —  such  classification  can  be  easily  carried 
out,  and  may  be  very  extensive  indeed.  There  are  also  certain 
necessary  outlays  during  the  period  of  construction  which  are 
.applicable  to  the  property  as  a  whole  but  not  to  any  specific 
tangible  result,  and  which,  therefore,  cannot  well  be  distributed 
in  the  accounts  on  a  functional  basis.  (See  Chapter  XIX.) 

Another  important  line  of  division  between  fixed  asset  ac- 
counts arises  in  cases  where  several  products  are  being  produced 
by  a  single  enterprise.  In  such  cases  the  ideal  arrangement 
would  be  the  segregation  in  a  special  group  of  accounts  of  the 
fixed  investment  devoted  to  the  production  of  each  type  of  com- 
modity or  service  —  with  further  classification  according  to 
phases  of  the  business  process  as  suggested  in  the  above  outline. 
Wherever  the  same  property  units  are  used  to  produce  several 


120  PRINCIPLES  OF  ACCOUNTING 

products,  however,  the  determination  of  the  investment  required 
for  each  line  is  a  problem  practically  impossible  of  rational  solu- 
tion. A  railroad  company,  for  example,  sells  both  passenger 
and  freight  service  but  practically  the  same  right-of-way,  roadbed, 
and  track  are  used  for  both  types  of  traffic.  It  would  therefore 
seem  a  very  unreasonable  procedure  to  attempt  to  apportion 
the  investment  in  "road"  between  the  two  services.  Yet  the 
central  problem  of  cost  accounting  is  the  classification  of  "costs" 
or  expense  according  to  commodities  or  services  produced ;  and 
this  virtually  involves  just  such  an  assignment  of  investment. 

It  should  be  evident  that  all  possible  transactions  which  might 
affect  the  subsidiary  fixed  asset  accounts  as  presented  in  a  detail 
classification  would  be  analyzed  according  to  the  general  prin- 
ciples illustrated  in  the  preceding  sections  of  this  chapter.  If  the 
asset  accounts  of  an  enterprise  are  numerous,  however,  greater 
care  must  be  exercised  in  determining  the  particular  account 
which  is  to  be  charged  or  credited  as  the  case  may  be. 

ACCOUNTS   WITH  CURRENT   TANGIBLE   ASSETS 

The  general  distinction  between  fixed  and  current  assets  has 
already  been  considered.  Summing  up  the  discussion  of  this 
matter  it  may  be  said  that  liquidity  and  length  of  life  are  the 
important  factors  to  be  recognized.  Length  of  life  may  refer 
to  either  of  two  conditions:  (i)  the  rate  with  which  an  asset 
expires  (or  passes  into  the  expense  category) ;  (2)  the  period 
during  which  an  asset  of  almost  constant  value  (such  as  a  con- 
tractual right)  is  held  by  a  particular  enterprise.  It  should  also 
be  remembered  that  certain  kinds  of  assets  may  be  either  current 
or  fixed  depending  upon  the  nature  of  the  enterprise  possessing 
the  asset  in  any  case.  The  factory  site  of  a  manufacturing  com- 
pany, for  example,  is  a  fixed  asset.  A  similar  parcel  of  land  held 
by  a  real  estate  company,  on  the  other  hand,  constitutes  a  cur- 
rent asset  —  the  merchandise  of  the  enterprise.  In  this  section 
the  important  classes  of  accounts  with  current  tangible  assets 
will  be  discussed. 

a.  First  under  this  head  will  be  considered  the  accounts  which 
represent  items  such  as  materials,  merchandise,  goods  in  process, 
finished  goods,  fuel,  stationery,  and  other  types  of  current  sup- 


THE  ASSET  ACCOUNTS  1 21 

plies  and  commodities.  Such  accounts  present  no  peculiar 
problems  of  analysis  (as  compared  with  the  accounts  with  tangible 
fixed  assets)  except  in  the  cases  where  a  current  asset  and  a 
revenue  are  included  in  the  same  account.  As  already  explained, 
the  account,  Merchandise,  as  often  used  by  a  trading  company, 
is  a  mixed  account,  representing  both  asset  and  equity  elements. 
The  accounts  Materials,  Goods  in  Process,  and  Finished  Goods, 
however,  which  are  used  in  factory  accounting,  can  be  considered 
as  typical  asset  accounts ;  for  in  these  cases  cost  prices  and  sc"ing 
prices  are  not  entered  in  the  same  account,  and  special  accounts, 
such  as  Sales,  are  used  to  show  gross  revenue.  The  difference 
between  these  two  cases  will  be  further  explained  in  Chapter  VIII. 

Many  transactions  affecting  such  accounts  occur  in  business 
practice.  A  large  number  of  the  purchase  and  sale  happenings 
which  furnish  the  bookkeeper  with  the  major  part  of  his  routine 
work  have  to  do  with  the  current  assets.  This  follows  naturally 
from  the  nature  of  these  items.  And,  although  current  assets 
remain  in  the  business  for  a  comparatively  short  period,  signifi- 
cant value  changes  may  occur  in  such  assets.  Raw  materials 
and  similar  items  may  appreciate  or  depreciate,  and  the  depre- 
ciation in  such  cases  may  be  due  either  to  price  declines  or  to 
physical  deterioration.  Obsolescence  is  also  a  possible  cause 
for  the  depreciation  of  some  current  assets.  Merchandise,  for 
example,  may  decline  in  value  because  of  seasonal  or  permanent 
changes  in  the  character  of  demand.  Normally  the  period  in 
which  a  specific  item  remains  in  the  business  is  so  short  as  to  make 
it  impracticable  to  attempt  to  show  these  changes  in  the  asset 
accounts.  The  clerical  labor  involved  would  be  too  great,  and 
the  correction  automatically  occurs  when  the  item  is  sold  and 
other  property  received  in  exchange.  But  when  the  period  of 
turnover  is  abnormally  long,  or  if  a  serious  change  in  price  occurs, 
it  becomes  desirable  to  make  the  necessary  adjustments  directly 
in  the  asset  accounts.  Valuation  accounts  can  be  used  in  record- 
ing the  decreases  in  value  due  to  depreciation,  as  in  the  case  of 
fixed  asset  accounts,  or  the  asset  account  can  be  credited  directly 
with  the  amount  of  the  expiration  in  any  case. 

Then  debits  to  the  Materials  account  of  the  A.  B.  Co.,  for  ex- 
ample, will  represent,  normally,  the  cost  of  materials  purchased. 
Credit  entries  in  this  account  will  usually  represent  the*  value  of 


122  PRINCIPLES  OF  ACCOUNTING 

materials  taken  from  the  warehouse  and  turned  over  to  the  fac- 
tory operatives.  Yet  if  it  be  assumed  that  it  is  the  function  of 
this  account  to  show  the  actual  value  of  the  materials  on  hand, 
any  significant  advance  in  the  prices  of  these  materials  would 
also  give  rise  to  a  debit  entry  for  the  amount  of  the  increase,  and 
any  decline  in  the  value  of  units  not  consumed  would  require  a 
credit  entry  (or  a  credit  entry  in  a  valuation  account). 

In  the  case  of  an  enterprise  doing  a  trading  as  well  as  a  manu- 
facturing business  credits  to  the  Materials  account  might  (in 
addition  to  the  occurrences  already  mentioned)  represent  the 
sale  of  materials  at  cost,  at  a  loss,  or  above  cost.  If  the  entire 
amount  of  each  sale  were  credited  to  Materials  in  such  a  case, 
this  account  would  become  a  mixed  account.  If  a  perpetual 
inventory  were  kept,  however,  the  credit  entries  recognizing 
such  sales  could  be  restricted  (as  far  as  Materials  were  con- 
cerned) to  the  amount  of  the  asset  subtraction  in  each  case. 
In  this  event  the  Materials  account  would  retain  its  character 
as  an  asset  account. 

The  following  transactions  illustrate  the  various  important 
cases : 

1.  Materials  are  purchased  for  cash,  $1,000.     The  transaction 
would  be  journalized  as  follows : 

Materials $1,000 

Cash $1,000 

This  is  a  typical  occurrence. 

2.  Materials  are  taken  from  the  warehouse  to  be  used  in  manu- 
facture.    The  entries  would  be : 

Goods  in  Process $500 

Materials $500 

This  is  another  normal  transaction.  Credits  can  be  made  to 
the  Materials  account  whenever  any  materials  whatever  are 
removed,  or  these  credits  may  be  made  only  at  certain  in- 
tervals. 

3.  It  is  estimated  that  materials  on  hand  have  decreased  in 
value  because  of  deterioration  and  unfavorable  price  changes, 
$500.     The  journal  entries  would  be : 


THE  ASSET  ACCOUNTS  123 

Expense $500 

Materials $500 

4.    Materials  are  sold  at  cost  for  cash,  $300.     The  journal 
entries  covering  this  situation  would  be : 

Cash $300 

Materials $300 

If  these  goods  were  sold  at  an  advance  of  $50,  the  entries  (assum- 
ing a  perpetual  inventory)  would  become : 

Cash $350 

Materials $300 

Revenue 50 

If  the  sale  were  below  cost,  $50,  the  entries  would  be : 

Cash $250 

Expense 50 

Materials $300 

If  the  entire  amount  of  the  sale  were  credited  to  Materials  in 
each  case  it  would  mean,  as  explained  above,  that  the  Materials 
account  was  being  used  as  a  mixed  account. 

The  accounts  with  tangible  current  assets  may  also  be  classi- 
fied on  a  functional  basis.  Thus,  instead  of  one  Materials  ac- 
count, an  enterprise  may  make  use  of  several  such  accounts  — 
an  account  for  each  type  of  raw  materials  or  a  special  account 
to  represent  the  value  of  the  raw  materials  to  be  devoted  to  each 
particular  product.  But  although  the  current  asset  accounts 
may  represent  an  important  part  of  a  firm's  investment,  if  a 
functional  classification  of  expense  accounts  is  carried  out  there 
is  little  advantage  in  classifying  current  assets  on  this  basis,  since 
specific  asset  items  rapidly  pass  into  the  expense  category. 

b.  Among  the  accounts  with  current  tangibles  Cash  is  suffi- 
ciently important  and  peculiar  to  be  given  special  consideration. 
Cash  is  an  account  found  almost  universally.  Being  the  ac- 
cepted legal  tender  cash  is  necessary  in  nearly  all  types  of  busi- 
ness operations.  (Checks,  money  orders  and  bank  drafts,  as 
well  as  actual  currency,  are  commonly  considered  as  cash  'when 
received  or  given.)  It  is  the  most  liquid  form  of  property.  Be- 


124  PRINCIPLES  OF  ACCOUNTING 

cause  of  its  availability  as  a  purchasing  and  debt-paying  medium 
cash  is  in  some  ways  the  most  desirable  form  of  property.  In 
accounting,  however,  the  tendency  is  to  lay  too  much  stress  upon 
the  importance  of  cash,  and  transactions  involving  cash.  Al- 
though cash  is  an  important  asset,  for  the  reasons  just  given,  the 
Cash  account  is  not  the  most  important  or  informational  account 
in  many  cases. 

The  chief  peculiarity  of  Cash  lies  in  the  fact  that  normally 
none  but  actual  "business"  transactions  affect  this  account. 
Exceptions  to  this  normal  condition  arise  in  the  case  of  lost  or 
stolen  cash  and  gifts.  Further,  if  the  gross  amount  of  checks 
and  drafts  is  charged  to  Cash  and  exchanges  and  other  deductions 
(such  as  a  tax  on  checks)  are  later  allowed,  such  items  require 
credits  to  Cash  for  the  amounts  involved.  Depreciation  and 
appreciation  do  not  usually  occur  in  connection  with  cash.  The 
value  (or  purchasing  power)  of  the  dollar  varies,  but  this  does 
not  appear  in  the  Cash  account  since  the  dollar  is  itself  the 
measuring  unit  which  is  applied  to  all  other  values. 

Transactions  (i)  and  (4)  under  (a)  above  illustrate  ordinary 
occurrences  affecting  the  Cash  account.  In  the  case  of  donations, 
or  lost  or  stolen  cash,  Cash  would  be  credited  and  Expense  debited 
(Expense  if  the  outlay  or  loss  is  of  ordinary  occurrence,  Net 
Revenue  or  Surplus  if  the  expiration  is  unusual  and  can  commonly 
be  avoided).  Changes  in  the  Cash  account  also  arise  in  trans- 
actions involving  concurrent  changes  in  equity  and  subsidiary 
equity  accounts.  The  following  transactions  are  illustrative 
of  such  cases : 

1.  A  invests  cash  in  business,  $5,000.     The  following  journal 
entries  would  be  made : 

Cash $5,ooo 

A,  Capital $5,ooo 

2.  A  promissory  note  against  the  enterprise  amounting  to 
$500  is  paid.     The  entries  would  be : 

Notes  Payable $500 

Cash ^ $500 

3.  Product  is  sold  for  cash,  $200.     The  entries  would  be  as 
follows : 


THE  ASSET  ACCOUNTS  125 

Cash $200 

Revenue $200 

4.  The  Net  Revenue  account  at  the  end  of  the  year  shows  a 
credit  balance  of  $1,200.     A  withdraws  this  amount  in  cash. 
Entries : 

Net  Revenue $1,200 

Cash $1,200 

5.  The  bank  charges  the  firm's  account  with  $3,  the  amount 
of  exchange  on  drafts  and  notes  deposited.     The  entries  on  the 
firm's  books  (assuming  that  the  gross  amount  of  checks  and  drafts 
were  charged  to  Cash  as  received)  would  be : 


Exchange    . 
Cash 


The  charge  to  the  Exchange  account  in  this  case  would  represent 
a  deduction  from  revenue  (assuming  the  funds  involved  were 
received  from  sales)  with  approximately  the  same  significance  as 
an  item  of  cash  discount  on  sales. 

The  large  part  of  a  firm's  cash  is  usually  deposited  with  some 
bank.  In  such  a  case  the  firm's  bank  book  shows  (in  summary 
form)  the  same  information  as  the  Cash  account  in  the  ledger. 
The  ledger  account  is  sometimes  considered  as  representing  the 
bank's  relation  to  the  enterprise  rather  than  a  tangible  asset, 
cash,  and  is  entitled  with  the  name  of  the  bank.  Indeed  it  should 
be  recognized  that  the  medium  used  in  modern  business  trans- 
actions consists  essentially  in  rights  against  banks  rather  than 
tangible  coin  or  other  forms  of  currency.  Cash,  then,  is  not 
usually  an  asset  represented  by  a  tangible  object  in  the  same  sense 
as  is  raw  material.  Nevertheless  the  claims  represented  by  a 
Cash  account  in  any  case  can  normally  be  converted  into  currency 
on  demand. 

It  is  usually  necessary  to  keep  some  cash  on  hand  from  which  to 
make  small  payments.  Such  cash  is  recorded  in  a  "Petty  Cash " 
account.  Sometimes  a  petty  cash  book,  or  journal,  is  also  kept. 
In  some  cases  all  funds  received  are  first  deposited,  and  then 
checks  are  drawn  at  intervals  to  secure  the  funds  needed  for  small 
payments.  If  disbursements  are  made  from  the  till  before  all 


126  PRINCIPLES  OF  ACCOUNTING 

receipts  are  deposited  a  record  of  such  items  is,  of  course,  neces- 
sary. In  most  businesses  safeguards  of  all  sorts  are  thrown  around 
the  Cash  account  so  as  to  prevent  defalcations.  In  some  cases 
an  inordinate  emphasis  is  placed  upon  such  arrangements  in  view 
of  the  neglect  of  other  important  matters.  A  theft  or  loss  of 
supplies  to  the  amount  of  $50  is  nearly  as  serious  a  matter  as  a 
misappropriation  of  cash  for  a  like  amount. 

ACCOUNTS   WITH   CURRENT   RIGHTS 

a.  First  under  this  head  may  be  grouped  the  accounts  which 
represent  current  rights  to  contractual  sums  against  other  in- 
dividuals and  enterprises  than  the  firms  on  whose  books  such 
accounts  appear.  Notes  Receivable  and  Accounts  Receivable 
are  the  common  examples.  In  the  typical  trading  or  manu- 
facturing enterprise  such  assets  as  notes  and  accounts  receivable 
arise  largely  through  the  sale  of  merchandise  or  finished  goods 
on  other  than  a  cash  basis.  Usually,  then,  an  account  receivable 
is  a  "book"  claim  against  a  customer  which  represents  the  fact 
that  goods  have  been  shipped  to  the  customer  and  that  payment 
has  not  yet  been  made.  The  correspondence  between  firm  and 
customer,  and  original  papers  such  as  the  bill  of  lading,  furnish 
evidence  of  the  authenticity  of  the  sale  and  the  validity  of  the 
account.  A  note  receivable,  likewise,  is  usually  a  claim  against 
a  customer,  consisting,  however,  in  the  customer's  written  promise 
to  pay  a  certain  sum,  with  or  without  interest  as  the  case  may 
be,  at  a  specified  date.  Such  an  instrument  may  be  given  at 
the  time  a  sale  is  made,  or  later,  to  settle  an  open  account. 

Accordingly  Accounts  Receivable  (as  well  as  the  customer's 
personal  account)  is  charged,  and  the  Sales  account  is  credited, 
with  the  amount  of  each  credit  sale.  Whenever  an  account  is 
paid  Accounts  Receivable  is  credited  for  the  amount  of  the  pay- 
ment. If  a  discount  is  allowed  at  the  time  of  payment  the 
amount  of  the  discount,  as  already  explained,  constitutes  a  deduc- 
tion from  the  revenue  previously  credited  to  the  Sales  account, 
and  hence  is  chargeable  either  to  that  account  or  to  a  special 
offset  account.  In  such  a  case  the  gross  amount  of  the  original 
charge,  rather  than  the  amount  paid,  is  credited  to  Accounts 
Receivable.  Notes  Receivable  is  charged  with  the  face  amount 


THE  ASSET  ACCOUNTS  127 

of  such  instruments  received,  and  is  credited  with  corresponding 
amounts  when  the  notes  mature  and  are  paid.  Transactions 
affecting  these  accounts  —  particularly  Accounts  Receivable  — 
are  naturally  of  very  common  occurrence  in  the  case  of  the  or- 
dinary enterprise. 

These  accounts  present  some  peculiarities.  Appreciation  of 
such  assets  as  notes  and  accounts  receivable  is  practically  im- 
possible, for  these  assets  are  current  in  character  and  represent 
contractual  amounts.  Depreciation  of  current  rights,  however, 
often  occurs.  In  the  case  of  nearly  every  business  enterprise  a 
more  or  less  considerable  subtraction  from  the  face  of  the  ac- 
counts receivable  must  be  made  at  intervals  to  represent  the 
estimated  amount  of  uncollectible  accounts.  It  is  common 
practice  to  credit  another  account,  Allowance  for  Uncollectible 
Accounts,  for  such  amounts,  in  lieu  of  Accounts  Receivable. 
Such  an  account  is  a  subsidiary  valuation  account  similar  to 
Allowance  for  Depreciation  of  Buildings.  It  is  particularly  im- 
portant that  Accounts  Receivable  should  show  original  figures, 
for,  as  explained  in  a  preceding  chapter,  a  subsidiary  ledger  lies 
back  of  this  account,  and  it  is  important,  in  any  such  case,  that 
the  account  in  the  general  ledger  be  allowed  to  retain  its  char- 
acter as  a  controlling  account.  The  entries  involving  valuations 
of  accounts  receivable  will  be  illustrated  in  Chapter  VIII.  Par- 
ticular notes  may  also  depreciate  or  even  prove  to  be  entirely 
worthless.  In  such  cases  it  is  necessary  to  credit  Notes  Receiv- 
able and  debit  an  expense  account  for  the  amount  of  the  expira- 
tion. 

The  beginner  often  experiences  some  difficulty  in  making  the 
entries  involved  in  transactions  which  affect  the  Notes  Receiv- 
able and  Interest  accounts.  One  or  two  illustrations  will  be 
given  at  this  point. 

i.  Merchandise  to  the  amount  of  $1,000  is  sold  and  a  six  per 
cent  note  for  sixty  days  is  received.  The  entries  on  the  books 
of  the  firm  making  the  sale  would  be : 

Notes  Receivable $1,000 

Merchandise  Revenue $1,000 

With  fifty  days  yet  to  run  the  note  is  assigned  to  a  bank  without 
change  in  the  rate  of  interest.  The  firm  receives  the  face  of  the 


128  PRINCIPLES  OF  ACCOUNTING 

note,  $1,000,  and  one- third  of  a  month's  interest,  $1.67.  The 
entries  covering  this  transfer  would  be : 

Cash $1,001.67 

Notes  Receivable $1,000.00 

Interest 1.67 

These  entries  show  an  addition  to  an  asset,  cash,  of  $1,001.67, 
and  a  subtraction  from  another  asset,  notes  receivable,  of  $1,000. 
The  balance  of  the  cash  received,  $1.67,  is  a  payment  for  capital- 
service  furnished  by  the  firm ;  and  the  credit  to  Interest  repre- 
sents this  item  of  net  revenue. 

2.  If  the  note  received  in  the  above  transaction  bore  no  in- 
terest, and  were  discounted  at  the  bank  fifty  days  from  the  date 
of  maturity  at  six  per  cent,  the  entries  would  be  quite  different. 
A  non-interest  bearing  note  is  not  worth  its  face  until  the  due 
date.  It  is  banking  practice  to  apply  the  stated  rate  of  discount 
to  the  future  sum  instead  of  to  the  actual  present  principal. 
Since  the  bank  in  this  case  must  wait  fifty  days  for  the  note  to 
mature,  the  face  of  the  note  would  be  discounted  for  this  period 
at  six  per  cent  in  computing  the  present  value.  The  entries  on 
the  books  of  the  firm  disposing  of  the  note  would  then  be : 

Cash $991.67 

Discount 8.33 

Notes  Receivable $1,000.00 

The  discount  in  this  case  is  a  valuation  item.  The  note  is  not 
worth  its  face.  The  credit  to  Merchandise  Revenue  —  in  (i) 
above  —  was  overstated,  and  the  discount  item  is  essentially  a 
deduction  from  the  nominal  revenue  figure. 

Firms  handling  but  small  amounts  of  commercial  paper  com- 
monly ignore  the  distinction  between  discount  and  interest,  and 
include  all  such  items  in  one  account.  While  this  procedure  is 
inaccurate  it  is  not  a  matter  of  great  significance  where  the 
amounts  involved  are  small.  Banks  and  similar  enterprises, 
however,  find  it  necessary  to  distinguish  carefully  between  the 
two  cases.  Discount  is  "future"  interest;  that  is,  it  becomes 
interest  as  the  date  of  maturity  for  the  instrument  involved 
approaches.  In  Part  Three  of  the  text  the  problems  of  compu- 


THE  ASSET  ACCOUNTS  129 

tation  and  analysis  involving  interest  and  discount  will  be  fully 
discussed. 

If  the  firm  negotiating  a  note  endorses  the  instrument  —  that 
is,  becomes  responsible  for  its  payment  in  case  the  original  maker, 
or  previous  endorser,  fails  to  meet  the  obligation  when  it  matures 
—  the  note  represents  a  contingent  liability  of  the  firm.  Un- 
doubtedly a  record  of  this  fact  should  be  made  in  any  case,  but 
it  may  not  be  desirable  to  attempt  to  show  this  information  in 
the  regular  ledger  accounts.  An  attempt  is  sometimes  made  to 
crowd  into  the  accounts  proper  data  which  are  somewhat  extra- 
neous. The  point  should  be  emphasized  again  that  there  is  much 
statistical  information  pertaining  to  a  business  enterprise  which 
does  not  belong  in  the  accounts.  Strictly  speaking,  only  asset 
and  equity  facts  —  or  facts  which  represent  phases  of  these 
classes  —  are  proper  matters  for  accounting  record.  In  pre- 
paring financial  statements,  however,  the  accountant  —  par- 
ticularly the  auditor  —  often  makes  use  of  auxiliary  information. 

If  such  a  contingent  liability  is  shown  in  the  accounts  it  is  de- 
sirable to  set  it  up  by  crediting  Notes  Receivable  Discounted, 
instead  of  Notes  Receivable,  with  the  amount  of  all  discounted 
paper.  Thus,  in  (2)  above,  the  entries  would  be: 

Cash $991.67 

Discount 8.33 

Notes  Receivable  Discounted  .     .     .  $1,000 

Such  an  account  represents  a  special  case  of  subtractions  from 
the  notes  receivable,  and  suggests  the  contingent  character  of 
these  subtractions.  The  use  of  contingent  items  in  balance 
sheet  statements  will  be  explained  in  a  later  chapter. 

Accepted  bills  of  exchange  are  in  effect  promissory  notes,  and 
are  usually  carried  in  the  Notes  Receivable  account.  Until 
such  an  instrument  is  accepted  by  the  payer,  however,  it  is  good 
practice  not  to  formally  enter  the  transaction.  Even  if  cash  is 
received  by  the  drawer  immediately  from  his  bank,  it  is  desirable 
to  simply  make  a  memorandum  to  that  effect,  and  omit  the 
record  of  the  transaction  in  the  accounts  proper  until  the  notifi- 
cation that  the  bill  has  been  accepted  is  received. 

b.  A  final  group  of  current  asset  accounts  includes  all  accounts 
which  represent  short-term  rights  to  services.  Whenever  pay- 


130  PRINCIPLES  OF  ACCOUNTING 

merit  for  a  service  is  made  prior  to  the  receipt  or  utilization  of 
the  service,  the  amount  of  the  payment  represents  a  current  asset. 
Prepaid  insurance,  advertising  and  rent  are  common  examples 
of  such  assets.  The  accounts  with  such  items  are  debited  when- 
ever the  services  which  they  represent  are  purchased.  At  in- 
tervals the  expirations  are  recognized  and  transferred  to  expense 
accounts.  Because  such  assets  are  highly  transitory  in  character 
and  contractual  in  amount  the  problems  of  valuation  involved 
are  particularly  simple. 

Whenever  payment  for  a  current  service  is  made  at  the  mo- 
ment the  service  is  consumed,  or  later,  the  account  representing 
the  service  can  be  considered  an  expense  account  as  explained 
in  Chapter  III.  In  general  it  may  be  said  that  this  group  of 
asset  accounts  "shades  into"  the  expense  accounts.  The  pay- 
ments for  services  such  as  insurance,  however,  are  normally 
made  in  advance  and  cover  a  considerable  period. 

The  following  transactions  illustrate  the  important  possi- 
bilities : 

1 .  The  firm  decides  to  run  an  advertisement  for  three  months 
in  a  local  newspaper.     A  payment  for  the  three  months'  adver- 
tising service  is  made,  $300.     The  entries  are  as  follows : 

Advertising $300 

Cash $300 

2.  An  inventory  is  taken  a  month  later,  and  the  expiration 
of  advertising  service  is  entered  thus : 

Expense $100 

Advertising $100 

3.  If  the  service  were  paid  for  after  being  consumed,  and  had 
not  previously  been  recognized  in  the  accounts,  the  entries  would 
become : 

Expense $300 

Cash $300 

The  transactions  discussed  in  this  chapter  illustrate  adjust- 
ments which  are  made  in  connection  with  inventories  and  ap- 
praisals as  well  as  entries  resulting  from  ordinary  purchase  and 


THE  ASSET  ACCOUNTS  131 

sale  happenings.  The  fact  has  been  emphasized  that,  as  far  as 
the  effect  upon  the  asset  account  in  any  case  is  concerned,  a  value 
change  in  either  direction  due  to  a  revaluation  of  remaining  units 
is  as  significant  as  a  change  due  to  the  addition  or  subtraction 
of  specific  units.  No  attempt  has  been  made  to  discuss  the 
technical  process  of  balancing  the  accounts  and  making  closing 
entries  after  the  valuations  are  made.  This  topic  will  be  con- 
sidered in  Chapter  VIII. 


VII 

FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS 

THE  equity  accounts  of  a  business  enterprise,  as  already  ex- 
plained, represent  the  facts  of  ownership.  It  is  the  function  of 
these  accounts  to  show  the  actual  investment  of  each  interest 
furnishing  capital  to  the  enterprise,  and  to  reflect  the  changes  in 
equities  due  to  the  variations  in  asset  values  resulting  from  nor- 
mal operating  conditions  and  other  causes.  In  this  chapter  the 
equity  accounts  will  be  discussed  under  the  following  heads : 
(i)  accounts  with  fixed  equities;  (2)  classes  of  expense  and 
revenue  accounts ;  (3)  net  revenue  and  surplus  accounts ;  (4) 
accounts  with  current  liabilities. 

ACCOUNTS    WITH   FIXED   EQUITIES 

As  in  the  case  of  the  assets,  the  equities  in  the  business  enter- 
prise may  be  divided  into  fixed  and  current  items.  A  particular 
equity  may  be  of  indefinite  life,  as  is  normally  the  case  with 
proprietorship,  or  an  equity  may  be  a  contractual  right  covering 
a  specified  period,  short  or  long.  In  this  section  cursory  con- 
sideration will  be  given  to  the  accounts  representing  fixed  (or 
" capital")  equities.1 

a.  Accounts  must  be  kept  in  each  case  to  show  the  proprietor's 
equity  —  the  original  and  accumulated  proprietorship.  As  ex- 
plained in  Chapter  II,  the  proprietor  is  the  owner  in  the  narrow 
sense.  It  is  this  interest  that  assumes,  in  large  measure,  the 
burden  of  risk  and  management  and  has  a  residual  right  to  assets 
as  income  or  principal.  In  an  enterprise  such  as  a  small  retail 
establishment,  where  nearly  all  of  the  capital  is  furnished  by  the 
"proprietor,"  it  is  the  essential  function  of  the  financial  records 

1  Part  Two  of  the  text  is  devoted  to  a  more  complete  discussion  of  the  proprietary 
and  fixed  liability  accounts  as  they  appear  under  different  forms  of  organization. 

132 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS     133 

to  show  proprietorship  and  the  change  in  this  equity  which  ac- 
crues during  each  period  of  operation.  If  outsiders  furnish  part 
of  the  capital  in  any  case,  however,  accounts  must  also  be  kept 
with  these  equities,  and  the  items  of  income  accruing  to  such 
interests  must  be  regularly  recognized  in  the  net  revenue  ac- 
counts. And  in  many  large  corporations  the  liabilities  exceed 
proprietorship  in  amount.  Yet  even  in  such  cases  the  final  goal 
of  accounting,  in  a  sense,  is  the  determination  of  proprietorship 
and  proprietary  income,  or  profit;  for  this  equity,  as  just  stated, 
is  the  residual  interest.  From  the  accounting  standpoint,  there- 
fore, proprietorship  is  the  most  important  equity  in  the  business 
enterprise. 

In  a  "single-proprietorship,"  or  in  a  partnership,  accounts 
headed  with  the  name  of  the  proprietor  or  the  names  of  the  dif- 
ferent partners  as  the  case  may  be,  are  commonly  used  to  repre- 
sent the  proprietary  equity.  In  the  case  of  a  corporation  it  is 
customary  to  consider  this  equity  as  being  identical  with  the 
claims  of  the  stockholders,  which  are  represented  by  the  capital 
stock  and  surplus  accounts.  This  is  a  somewhat  arbitrary  con- 
ception of  proprietorship,  because  of  the  impersonal  character 
of  this  (or  any  other)  equity  under  the  corporate  form  of  organi- 
zation, and  because  of  the  marked  differences  in  the  rights  rep- 
resented by  the  various  kinds  of  capital  stock  (see  Chapter  XII). 

Capital  stock  is  listed  in  the  accounts  at  its  par  or  formal  value, 
and  hence  does  not  often  exactly  represent  the  original  invest- 
ment of  the  stockholders.  A  valuation  account,  Discount  on 
Stock,  should  be  used  to  record  offsets  to  corporate  proprietor- 
ship at  the  time  of  organization.  Premium  on  Stock,  or  a  similar 
account,  may  be  used  to  represent  the  excess  of  the  original 
proprietorship  over  the  par  of  the  capital  stock  in  any  case. 
Surplus,  according  to  general  usage,  represents  proprietary  in- 
come retained  in  the  business.  This  item,  in  practice,  is  repre- 
sented by  variously  named  accounts.  Surplus,  Undivided  Profits, 
Profit  and  Loss,  Loss  and  Gain,  are  the  common  examples.  In 
addition  to  the  general  surplus  account  there  may  be  special 
accounts  which  represent  in  each  case  a  portion  of  surplus  ap- 
propriated for  a  particular  purpose.  Examples  of  such  accounts 
are  Sinking  Fund  Reserve  and  Reserve  for  Improvements.  (See 
Chapter  XIII  for  a  special  discussion  of  surplus  appropriations.) 


134  PRINCIPLES  OF  ACCOUNTING 

The  fixed  proprietary  accounts  are  credited  with  all  invest- 
ments and  all  net  proprietary  earnings  which  are  not  immediately 
distributed,  and  are  charged  with  all  withdrawals  and  all  net 
losses.  The  transactions  directly  affecting  this  group  of  accounts 
are  made  for  the  most  part  either  at  the  time  of  organization  or 
at  the  end  of  an  accounting  period,  and  hence  cannot  be  explained 
in  detail  until  the  process  of  closing  the  accounts  has  been  dis- 
cussed. In  these  accounts,  as  in  all  equity  accounts,  debits 
always  indicate  subtractions,  and  credits  always  indicate  addi- 
tions. ! 

The  following  are  illustrations  of  a  few  typical  transactions  : 

1.  The  subscribers  pay  in  $10,000  in  cash,  and  stock  is  issued 
to  them  for  this  amount.     Entries : 

Cash $10,000 

Capital  Stock $10,000 

2.  The  above  stock  is  subscribed  at  $90  per  share,  par  $100. 
The  subscriptions  are  paid  and  the  stock  is  issued.     In  summary 
form  the  entries  would  be  as  follows : 

Cash $9,000 

Discount  on  Capital  Stock 1,000 

Capital  Stock $10,000 

3.  The  same  as  (2)  except  that  the  stock  is  subscribed  at  $110 
per  share.     Entries : 

Cash $11,000 

Capital  Stock $10,000 

Premium  on  Capital  Stock     .     .     .  1,000 

4.  The  amount  of  net  revenue  accruing  to  the  stockholders, 
$1,000,  is  transferred  to  Surplus,  thus: 

Net  Revenue $1,000 

Surplus $1,000 

5.  An  appropriation  of  $3,000  as  a  reserve  for  improvements 
is  made  by  the  directors.     This  transaction  involves  simply  a 
subtraction  from  a  general  surplus  account  and  an  addition  to  a 
special  surplus  account.     The  entries  accordingly  would  be : 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS      135 

Surplus $3,000 

Reserve  for  Improvements     .     .     .  $3,000 

b.  In  practice  all  long-term  equities  other  than  proprietorship 
constitute  the  capital  liabilities  of  an  enterprise.  Notes  payable 
(long-term  notes),  mortgages,  bonds,  and  similar  securities  are 
the  common  examples  of  such  equities.  These  items  represent 
contractual  rights  to  income  and  principal,  and  hence  seldom  in- 
crease because  of  invested  earnings  or  decrease  because  of  losses.1 
As  in  the  case  of  capital  stock,  the  par  or  face  of  a  fixed  liability 
may  be  more  or  less  than  the  actual  investment.  Accordingly  a 
special  account  is  necessary  for  such  a  case  to  show  the  amount 
of  discount  or  premium. 

Since  the  fixed  liabilities  are  contractual,  debits  in  the  accounts 
with  such  items  usually  indicate  subtractions  due  to  the  payment 
of  the  obligation  in  any  case  with  some  kind  of  property  (nor- 
mally cash) ,  or  to  the  exchange  of  one  equity  for  another.  Sim- 
ilarly, credits  indicate  additions  made  concurrently  with  the 
receipt  of  property  or  a  corresponding  reduction  in  another  equity. 
The  Mortgages  Payable  account,  for  example,  would  be  credited 
with  the  amount  of  all  mortgages  issued  and  charged  with 
the  amount  of  all  mortgages  retired.  These  entries  would  nor- 
mally cover  the  contractual  sums  specified  in  the  mortgage  con- 
tract. Only  in  the  case  of  liquidation  or  reorganization  would 
it  be  necessary  to  make  entries  in  such  an  account  for  any  deduc- 
tions from  the  contractual  amounts. 

The  following  transactions  illustrate  the  ordinary  cases : 

1.  Bonds  are  issued  for  cash  at  par,  $10,000.     Entries  : 

Cash $10,000 

Bonds  Payable $10,000 

2.  The  bonds  mentioned  in  (i)  are  retired  with  cash,  $10,000. 
The  entries  would  be  the  reverse  of  the  above  : 

Bonds  Payable $10,000 

Cash $10,000 

1  The  amortization  of  premiums  and  the  accumulation  of  discounts  may  be 
thought  of  as  representing  decreases  and  increases,  respectively,  in  bondholders' 
equities.  These  transactions  are  complex  and  will  be  discussed  in  a  later  chapter. 


136  PRINCIPLES  OF  ACCOUNTING 

3.  Mortgages  to  the  amount  of  $10,000  are  retired  and  bonds 
are  issued  in  exchange  for  the  same  amount.     The  entries  would 
be: 

Mortgages  Payable $10,000 

Bonds  Payable $10,000 

4.  Bonds,  par  $10,000,  are  issued  at  a  premium  of  ten  per  cent. 
Entries : 

Cash $11,000 

Bonds  Payable $10,000 

Premium  on  Bonds 1,000 

5.  Bonds,  par  $10,000,  are  issued  at  a  discount  of  ten  per  cent. 
The  entries  on  the  issuing  corporation's  books  would  be : 

Cash $9,000 

Discount  on  Bonds 1,000 

Bonds  Payable $10,000 


CLASSES  OF  EXPENSE  AND  REVENUE  ACCOUNTS 

Expense  and  revenue  accounts,  as  explained  in  Chapter  III, 
are  subsidiary  equity  accounts.  Revenue  accounts  are  credited 
with  all  sales  of  product  —  gross  additions  to  equities.  Ex- 
pense accounts  are  charged  with  the  amount  of  all  services  and 
commodities  consumed  —  deductions  from  revenue.  The  net 
result  of  these  two  groups  of  accounts  is  the  net  revenue  (or  net 
loss}  from  operations  for  a  given  period.  In  other  words  it  is 
the  function  of  the  expense  and  revenue  accounts  to  present  an 
exhibit  of  the  productive  process  for  each  accounting  period,  and 
to  show  the  net  effect  of  that  process  upon  the  status  of  the 
equities  —  particularly  proprietorship. 

A  simple  illustration  will  serve  to  emphasize  further  the  gen- 
eral significance  of  these  subsidiary  accounts.  A  particular  firm, 
it  may  be  assumed,  makes  use  of  the  following  accounts  with 
expense  and  revenue  items  :  Materials  Expense ;  Fuel  Expense ; 
Labor  Expense ;  Depreciation  Expense ;  Sales  of  Product ;  and 
Rent  Revenue.  The  relation  between  these  accounts  can  be 
shown  thus : 


Materials  Expense 


Sales  of  Product 


Fuel  Expense 


Rent  Revenue 


Labor  Expense 


Depreciation  Expense 


The  net  balance  of  these  accounts  for  a  given  period  is  the  amount 
which  is  carried  to  the  Net  Revenue  account.  If  expenses  exceed 
revenues  the  difference  will  be  a  charge  to  Net  Revenue;  if 
revenues  are  in  excess  the  difference  is  a  credit  to  Net  Revenue. 
The  Net  Revenue  account  will  then  show  the  amount  available 
for  distribution  among  the  various  equities. 

The  following  occurrences  illustrate  transactions  affecting  the 
expense  accounts : 

1 .  An  appraisal  shows  that  the  company's  buildings  have  de- 
clined in  value,  $1,000.    This  transaction  would  be  journalized 
as  follows : 

Depreciation  Expense $1,000 

Buildings $1,000 

2.  Fuel  has  been  consumed  during  the  month,  $200.     Entries: 
Fuel  Expense $200 


Fuel 


$200 


138  PRINCIPLES  OF  ACCOUNTING 

3.  Labor  services  are  purchased  and  utilized  to  the  amount 
of  $300.     The  journal  entries  would  be : 

Labor  Expense $300 

Cash $300 

4.  Materials  have  been  utilized,  $500.     The  entries  would  be 
as  follows : 

Materials  Expense $500 

Materials $500 

The  following  transactions  involve  credits  to  the  revenue  ac- 
counts : 

1.  Goods  are  sold  for  cash,  $500.     Entries: 

Cash $500 

Sales  of  Product $500 

2.  The  firm  receives  a  month's  rent,  $100,  for  the  use  of  a  part 
of  its  building.     The  entries  would  be : 

Cash x $100 

Rent  Revenue $100 

Further  illustrations  of  transactions  involving  expense  and 
revenue  items  will  be  given  in  the  next  chapter. 

It  is  evident  that  as  far  as  the  integrity  of  the  net  revenue  figure 
is  concerned  in  any  case  all  expense  and  revenue  items  might  be 
listed  in  the  debit  and  credit  columns,  respectively,  of  a  single 
account.  If  there  were  no  omissions  or  other  errors  the  net  re- 
sult would  be  the  same  as  it  would  be  if  a  large  number  of  dis- 
tinct accounts  were  used.  (In  any  case  such  a  summary  account 
is  a  convenient  device,  and  its  use  will  be  explained  in  Chapter 
VIII.)  The  point  should  be  emphasized  at  this  stage,  however, 
that  the  detail  classification  of  expense  and  revenue  accounts 
for  managerial  purposes  is  one  of  the  most  important  matters  in 
modern  accounting.  Brief  consideration  will  be  given  to  this 
topic  in  this  section. 

In  the  case  of  an  enterprise  of  any  complexity  it  is  not  suffi- 
cient that  total  expense  and  total  revenue  be  correctly  shown  in 
the  accounts.  The  net  earnings  of  the  business  can  be  determined 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS      139 

by  combining  these  figures,  and  a  rough  test  of  efficiency  may  be 
had  by  comparing  the  expense  and  revenue  totals  in  a  particular 
period  with  the  corresponding  figures  for  preceding  periods.  But 
the  management  should  have  at  its  disposal  much  more  elaborate 
information  than  this.  As  far  as  possible  all  the  expenses  appli- 
cable to  each  important  department  or  phase  of  the  business 
should  be  segregated  in  the  accounts.  Further,  the  expenses 
incident  to  the  use  of  each  important  type  of  fixed  asset  and  each 
current  service  or  commodity  might  well  be  grouped  in  a  special 
account.  Only  from  such  classifications  of  expense  accounts  is 
it  possible  for  the  manager  to  secure  the  data  necessary  for  mak- 
ing comparisons  to  determine  the  relative  efficiencies  of  particular 
plants,  departments,  processes,  etc.,  and  in  fixing  the  responsi- 
bilities of  employees. 

Still  further,  if  a  firm  is  producing  several  products  it  is  highly 
desirable  that  the  expenses  incident  to  the  production  of  each 
line,  in  so  far  as  they  can  be  isolated,  should  be  charged  to  a 
special  group  of  expense  accounts.  An  enterprise  may  discover, 
for  example,  after  making  such  a  functional  analysis  of  expense 
charges,  that  a  particular  product  is  being  manufactured  at  an 
actual  loss  although  the  business  as  a  whole  has  been  making  a 
fairly  satisfactory  showing.  In  such  a  case,  obviously,  net 
earnings  can  be  increased  by  further  specialization.  The  essen- 
tial problem  of  cost  accounting,  as  will  be  explained  in  Chapter 
XXIX,  is  the  classification  and  distribution  of  expense  charges 
in  the  accounts  of  an  enterprise  in  such  a  way  as  to  reveal  the 
actual  cost  of  each  important  product. 

The  following  is  an  illustration  of  a  simple  classification  of 
expense  accounts  for  a  manufacturing  enterprise : 

MANUFACTURING 

Maintenance  of  Factory  Building ; 
Depreciation  of  Factory  Building ; 
Maintenance  of  Factory  Equipment ; 
Depreciation  of  Factory  Equipment ; 
Maintenance  of  Transportation  Equipment ; 
Depreciation  of  Transportation  Equipment ; 
Materials  Expense ; 
Factory  Supplies ; 
Wages  of  Operatives ; 


I4o  PRINCIPLES  OF  ACCOUNTING 

Superintendence ; 

Wages  of  Drivers ; 

Wages  —  Miscellaneous ; 

Fuel  Expense ; 

Inward  Freight ; 

Power  and  Light ; 

Miscellaneous  Factory  Expense. 


SELLING 

Maintenance  of  Warehouse ; 

Depreciation  of  Warehouse ; 

Maintenance  of  Equipment ; 

Depreciation  of  Equipment ; 

Supplies ; 

Salesmen's  Salaries ; 

Wages  of  Shippers  and  Packers ; 

Miscellaneous  Wages ; 

Traveling  Expenses ; 

Heat  and  Light ; 

Outward  Freight ; 

Advertising ; 

Other  Selling  Expense. 


GENERAL 

Maintenance  of  Office  Building ; 

Depreciation  of  Office  Building ; 

Depreciation  of  Office  Equipment ; 

Office  Supplies ; 

Salaries  of  Clerical  Force ; 

Heat  and  Light ; 

Officers'  Salaries; 

Insurance ; 

Taxes.1 

It  is  evident  that,  in  apportioning  expense  charges  between 
departments  and  phases  of  an  enterprise,  difficulties  arise  similar 
to  those  mentioned  in  the  preceding  chapter  in  the  discussion  of 
the  functional  classification  of  the  accounts  with  fixed  assets. 
The  power  plant  in  the  factory  building,  for  example,  may  be 

1  There  is  some  question  as  to  the  legitimacy  of  considering  taxes  an  expense. 
In  the  next  section  of  this  chapter  this  problem  will  be  briefly  discussed. 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS     141 

used  to  furnish  heat  and  light  to  the  warehouse  and  office  build- 
ing as  well  as  to  the  factory.  In  such  a  case  the  distribution  of 
fuel  expense  and  other  charges  incident  to  the  operation  of  the 
power  plant  between  the  three  main  classes  of  expense  accounts 
shown  above  on  any  but  an  arbitrary  basis  is  obviously  a  diffi- 
cult matter.  Similarly,  the  same  transportation  equipment  in 
a  particular  case  may  be  used  indiscriminately  to  haul  raw  mate- 
rials from  the  freight  depot  and  to  deliver  finished  goods  to  the 
railroad  company  or  directly  to  a  customer's  warehouse. 

When  it  is  further  attempted  to  classify  expenses  in  terms  of 
costs  incident  to  the  production  of  each  important  type  of  product 
in  any  case,  added  difficulties  in  analyzing  particular  expenditures 
are  encountered.  Many  classes  of  current  services  and  commod- 
ities are  normally  utilized  in  the  production  of  more  than  one 
line.  A  particular  type  of  skilled  labor,  for  example,  —  or  even 
specific  laborers,  —  may  be  employed  at  different  times  upon 
work  connected  with  several  products.  Further,  the  fixed  assets 
are  usually  much  less  completely  specialized  than  the  current 
assets.  A  single  factory  building,  for  example,  may  be  used  in 
the  production  of  several  distinct  lines  of  goods.  Obviously,  in 
such  a  case,  the  maintenance  and  depreciation  charges  applicable 
to  the  building  must  be  distributed  in  the  expense  accounts  on  a 
rather  arbitrary  basis. 

The  revenue  accounts  will  normally  be  fewer  in  number  than 
the  expense  accounts.  An  enterprise  usually  buys  a  long  list  of 
commodities  and  services  even  if  but  a  single  type  of  commodity 
or  service  is  produced.  And  although  a  functional  classification 
of  revenues  is  an  important  matter  in  the  case  of  an  enterprise 
manufacturing  or  handling  several  lines,  it  does  not  present  the 
difficulties  that  arise  in  distributing  expense  charges  on  a  similar 
basis.  In  the  case  of  a  retail  drygoods  company,  for  example, 
while  it  might  require  considerable  clerical  labor  to  ascertain  the 
exact  amount  of  the  sales  of  each  kind  of  goods  handled  no  dif- 
ficult problems  of  analysis  would  arise.  It  would  be  necessary 
simply  to  follow  actual  business  transactions  as  they  appeared 
on  the  sale  slips  or  other  records.  In  such  a  case  it  would  not  be 
expedient,  however,  to  set  up  a  special  revenue  account  with 
each  minor  type  of  commodity  sold.  The  inconvenience  of  such 
a  system  would  more  than  offset  its  advantages.  But  each  im- 


142  PRINCIPLES  OF  ACCOUNTING 

portant  class  of  sales  might  well  be  credited  to  a  special  revenue 
account. 

The  following  list  illustrates  a  possible  classification  of  revenue 
accounts  for  a  company  manufacturing  agricultural  implements 
and  doing  a  wholesale  business  in  certain  kinds  of  tools  and  other 
hardware  supplies  as  well : 

IMPLEMENTS 

Sales  of  Binders ; 

Sales  of  Wagons ; 

Sales  of  Hay  Loaders  and  Tedders ; 

Sales  of  Mowers ; 

Sales  of  Cultivators  and  Harrows ; 

Sales  of  Drills  and  Seeders ; 

Sales  of  Other  Implements. 


HARDWARE 

Sales  of  Carpenters'  Tools ; 
Sales  of  Hardware  Supplies. 


OTHER  REVENUE 

Rent  of  Offices ; 
Royalties. 


It  can  readily  be  seen  that  the  expense  and  revenue  accounts 
of  a  large  and  complex  enterprise,  if  classified  in  any  detail,  may 
be  very  numerous  indeed.  The  classification  of  operating  rev- 
enues and  operating  expenses  of  steam  roads  prescribed  by  the 
Interstate  Commerce  Commission  in  1914  contains  about  two 
hundred  primary  expense  accounts  (grouped  under  eight  general 
heads)  and  thirty-nine  primary  revenue  accounts  (under  four 
main  heads).  It  should  be  recognized,  however,  that  no  matter 
how  far  the  division  of  these  subsidiary  equity  accounts  be  carried 
in  any  case,  the  relation  of  such  accounts  to  the  net  revenue  figure 
and  to  the  balance  sheet  equities  is  the  same  as  in  the  simple  case 
where  but  one  or  two  accounts  are  used. 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS      143 
NET  REVENUE   AND   SURPLUS   ACCOUNTS 

The  general  relation  of  the  Net  Revenue  and  Surplus  accounts 
to  the  balance  sheet  classes  was  explained  in  Chapter  III ;  and 
several  references  have  been  made  in  the  preceding  pages  to  the 
possible  use  of  these  accounts  to  reflect  variations  in  the  values 
of  fixed  assets  which  arise  outside  of  the  normal  course  of  business 
operation.  In  this  section  these  matters  will  be  briefly  reviewed, 
and  some  consideration  will  be  given  to  the  important  types  of 
subsidiary  net  revenue  and  surplus  accounts. 

The  most  important  function  of  the  general  Net  Revenue  ac- 
count in  any  case,  as  already  explained,  is  to  show  the  net  result 
of  the  expense  and  revenue  accounts  for  a  particular  period,  or, 
in  other  words,  the  net  revenue  figure,  and  the  apportionment  of 
this  amount  among  the  various  equities  in  the  enterprise.  This 
account  is  therefore  credited  with  the  amount  of  net  revenue  and 
is  debited  with  all  accruals  to  the  contractual  equities  and  all 
distributions  of  proprietary  income.  Further,  items  of  net  in- 
come arising  from  extraordinary  causes  and  from  ancillary  opera- 
tions may  be  credited  to  this  account ;  and  unusual  deductions 
from  ownership,  analogously,  may  be  charged  to  Net  Revenue. 
The  balance  of  this  account,  if  a  credit  amount,  represents  pro- 
prietary earnings  allowed  to  remain  in  the  business,  and  may  be 
credited  to  Surplus.  If  a  debit  amount  this  balance  represents 
a  decrease  in  proprietorship  and  hence  constitutes  a  charge  to 
the  Surplus  account. 

If  the  assets  of  an  enterprise  are  represented  by  a  single  equity 
one  account  will  suffice  to  show  the  distribution  and  adjustment 
of  the  net  revenue  figure.  If  there  are  several  distinct  equities 
involved  a  separate  account  with  each  equity  may  be  desirable. 
The  most  important  general  distinction  in  this  connection  is 
between  accounts  representing  accruals  to  contractual  equities 
(interest)  and  those  which  show  the  distribution  of  proprietary 
income  (dividends,  for  example).  Further,  net  losses  and  gains, 
and  items  of  net  income  such  as  interest  and  dividend  accruals 
on  securities  owned  by  the  enterprise,  may  be  set  up  in  special 
accounts.  All  such  accounts  are  subsidiary  net  revenue  ac- 
counts ;  and  their  relation  to  the  general  Net  Revenue  account 
can  be  shown  thus  : 


144 


PRINCIPLES  OF  ACCOUNTING 

NET  REVENUE 


Net  Operating  Deficit 

Net  Operating  Revenue 

Los 

ses 

Ga 

ins 

Inte 

rest 

Intt 

Test 

Divic 

lends 

Divic 

lends 

The  Dividends  account  represents  either  appropriations  and 
distributions  to  the  proprietors  of  an  enterprise  (stockholders 
in  the  case  of  a  corporation) ,  or  additions  to  net  revenue  received 
as  income  from  securities  held  in  other  enterprises.  Dividends 
received  are  net  rather  than  gross  revenue  because  such  items 
represent  income  resulting  from  the  sale  of  the  service  of  owner- 
ship itself,  and  consequently  no  expirations  of  capital  (sup- 
posedly) are  involved.  Similarly  the  Interest  account  shows 
either  the  distribution  of  net  revenue  to  the  contractual  equities 
or  net  revenue  accrued  as  a  result  of  the  ownership  of  such  rights. 
In  the  case  of  a  corporation  having  outstanding  a  variety  of  con- 
tractual liens  and  securities  as  well  as  several  classes  of  stocks  a 
considerable  number  of  such  subsidiary  net  revenue  accounts 
may  be  employed. 

Although  in  general  the  distinction  between  the  expense  and 
revenue  and  the  net  revenue  accounts  is  clear,  there  are  certain 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS     145 

accounts  which  may,  with  some  reason,  be  classed  in  either  group. 
The  account  which  shows  tax  accruals  in  any  case,  or  the  rela- 
tion of  the  enterprise  to  the  state,  is  one  of  these  liminal  cases. 
As  pointed  out  in  Chapter  I  the  rights  of  the  private  equities 
in  the  assets  of  a  business  enterprise  are  always  subject  to  revision 
by  the  tax  power  of  the  government.  The  state's  right  con- 
stitutes a  prior  lien  on  assets,  and  in  the  case  of  the  general 
property  tax  this  right  is  exercised  whether  earnings  exist  or  not. 
Normally,  however,  the  earnings  of  an  enterprise  are  more  than 
sufficient  to  offset  all  tax  accruals.  Now  it  would  seem  that  tax 
payments  or  accruals  can  hardly  be  considered  as  items  of  ex- 
pense. Expense  charges  are  deductions  from  revenue  which 
arise  because  of  the  expiration  of  services  and  commodities  in 
business  operation,  and  any  service  which  the  state  furnishes  to 
the  business  enterprise  can  hardly  be  conceived  as  a  specific 
valuable  consideration  from  the  accounting  standpoint.  The 
service  is  too  vague,  and  usually  does  not  vary  in  proportion  to 
the  size  of  the  tax  levy.  The  payments  are  coerced,  and  are 
not  analogous  to  market  prices  for  definite  services  or  commodi- 
ties. On  the  other  hand,  payments  to  the  government  cannot, 
with  entire  propriety,  be  considered  as  distributions  to  an  equity 
since  the  state's  claim  does  not  appear  upon  the  books  except  as 
it  is  entered  as  an  accrual  from  time  to  time.  This  is  one  of  those 
questions  that  cannot  be  decided  arbitrarily  according  to  general 
principles.  Either  viewpoint  may  be  legitimate  under  certain 
circumstances.  It  depends  upon  the  immediate  use  that  is  to 
be  made  of  the  accounts  involved  in  any  case.  From  the  man- 
ager's standpoint  taxes  are  not  an  expense  charge,  for  he  is  in  no 
way  responsible  for  the  outlay.  From  the  standpoint  of  the 
investor  such  payments  have  essentially  the  same  significance 
as  wages  or  any  other  expense,  since  the  amount  of  such  charges 
must  be  deducted  before  the  sum  available  for  distribution  among 
the  private  equities  is  determined.  On  the  whole  the  view  that 
the  Taxes  account  is  a  subsidiary  net  revenue  account  seems  the 
more  logical  opinion.  Further  attention  to  this  difficult  point 
will  be  given  in  a  later  chapter. 

Rent  charges  and  credits  are  sometimes  confused  with  net 
revenue  items.  While  such  entries  represent  contractual  ac- 
cruals it  does  not  follow  that  the  Rent  account  is  in  the  net  rev- 


146  PRINCIPLES  OF  ACCOUNTING 

enuc  category.  A  firm,  for  example,  leases  a  part  of  its  building 
to  outside  interests.  How  are  the  payments  to  the  firm  to  be 
considered?  Clearly  these  are  items  of  gross  revenue,  because 
depreciation  and  other  expenses  are  involved  in  the  production 
of  this  revenue.  Rent,  or  hire,  usually  amounts  to  ten  per  cent 
or  more  of  the  value  of  the  property  leased.  Only  from  a  third 
to  a  half  of  this  amount  is  net  revenue.  Further,  rent  expense  is 
not  a  disposition  of  net  revenue,  but  is  a  genuine  expense.  When 
a  firm  leases  an  asset  from  an  outside  party  the  payment  it  makes 
(assuming  payment  to  be  made  in  advance)  represents  the  pur- 
chase of  a  definite  privilege  or  service.  As  this  service  expires 
the  amount  of  the  expiration  becomes  an  expense  charge.  This 
situation  is  analogous  to  the  purchase  and  expiration  of  any  asset. 
If  payment  is  made  after  the  utilization  of  the  service  the  amount 
of  the  payment  can  be  considered  an  immediate  charge  to  an 
expense  account.  One  might  as  well  say  that  merchandise  rev- 
enue (gross  sales)  before  the  deductions  are  made  is  net,  as  to 
consider  the  typical  rent  accrual  as  a  net  charge  or  credit  to  the 
equities. 

The  use  of  the  Surplus  account  to  represent  a  part  of  the  pro- 
prietary equity  has  already  been  explained.  Since  surplus  arises 
primarily  through  the  retention  of  profits  in  the  enterprise  in 
any  case  it  is  evident  that  the  Surplus  account  will  be  credited 
with  all  net  revenue  balances  which  are  not  distributed  among 
the  private  equities,  paid  to  the  state  as  taxes,  or  otherwise  dis- 
posed of.  Further,  special  deductions  from  proprietorship 
(losses)  and  extraordinary  additions  to  this  equity  (gains)  may 
appropriately  be  carried  directly  to  Surplus  rather  than  to  the 
Net  Revenue  account. 

As  already  suggested,  a  particular  enterprise  may  make  use 
of  several  special  surplus  accounts.  The  relation  between  the 
general  Surplus  account  and  subsidiary  accounts,  positive  and 
negative,  is  shown  in  the  exhibit  on  page  147. 

In  the  case  of  a  single-proprietorship  or  a  partnership  the  per- 
sonal and  capital  accounts  of  the  proprietors  are  usually  directly 
charged  or  credited  with  items  of  deficit  or  surplus  as  the  case 
may  be.  Small  businesses  may  likewise  dispense  with  an  adjust- 
ment Net  Revenue  account.  But  in  large  enterprises,  particu- 
larly under  the  corporate  form  of  organization,  several  subsidiary 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS      147 

equity  accounts  are  commonly  necessary.  In  later  chapters 
the  Net  Revenue  and  Surplus  accounts  will  be  considered  in  more 
detail.  The  general  significance  of  these  accounts,  however, 
and  the  nature  of  their  typical  subdivisions,  should  be  clearly 
recognized  at  this  stage. 

SURPLUS 


Accumulated  Deficit 

Accumulated  Profit 

Losses  from  A 

Abandonments 

Reserve  for  '. 

mprovements 

ACCOUNTS   WITH   CURRENT   LIABILITIES 

a.  First  under  this  head  will  be  considered  the  accounts  rep- 
resenting current  claims  against  the  enterprise  which  arise  pri- 
marily through  the  purchase  of  materials  or  other  assets  on  credit 
and  through  borrowings  of  current  funds.  The  common  ex- 
amples are  Notes  Payable  and  Accounts  Payable.  The  lia- 
bilities represented  by  such  accounts  constitute  the  floating  in- 
debtedness of  an  enterprise.  That  is,  although  such  items  are 
equities  in  the  strict  sense  of  the  term,  the  holders  of  specific 
notes  and  accounts  furnish  the  cash  and  other  assets  involved 
temporarily  and  not  with  the  intention  of  allowing  their  capital 
to  remain  in  this  form.  Consequently  these  claims  do  not  rep- 
resent investment  as  such.  Nevertheless,  although  specific 
items  may  remain  as  equities  for  very  short  periods,  the  total 
of  such  liabilities  on  the  books  of  a  particular  firm  may  represent 
continuously  a  significant  sum.  This  means  that  in  such  a  case 
a  considerable  fraction  of  the  total  assets  of  the  business  is  rep- 
resented among  the  equities  by  current  liabilities,  although  the 
personnel  of  the  holders  of  these  claims  is  constantly  shifting. 

Credits  to  these  accounts  represent  additions  to  the  equities 


148  PRINCIPLES  OF  ACCOUNTING 

involved,  and  debit  entries  indicate  subtractions.  Except  in 
the  case  of  insolvency  or  reorganization  no  deductions  will  or- 
dinarily be  made  from  current  or  other  liabilities  but  such  charges 
as  represent  the  retiring  of  the  obligation  in  any  case  with  cash 
or  an  equivalent.  As  explained  in  Chapter  IV,  however,  both 
accounts  receivable  and  payable  are  often  entered  in  the  ac- 
counts at  gross  figures,  and  deductions  are  later  allowed.  In- 
come does  not  accrue  on  book  accounts,  but  even  short-term 
notes  may  be  interest-bearing  as  explained  in  the  case  of  notes 
receivable. 

The  following  transactions  are  typical  of  the  occurrences  af- 
fecting the  accounts  with  these  current  liabilities : 

1.  Supplies  are  purchased  on  account  from  the  S.  Company 
amounting  to  $400  at  the  gross  billed  price.     The  journal  entries 
on  the  books  of  the  purchaser  would  be : 

Supplies $400 

Accounts  Payable $400 

(S.  Company) 

2.  A  two  per  cent  discount  is  offered  on  the  account  mentioned 
in  (i)  if  cash  payment  is  made  within  ten  days.     This  discount 
is  accepted.    The  entries  would  be  as  follows : 

Accounts  Payable $400 

(S.  Company) 

Cash ' $392 

Purchase  Discounts 8 

Such  a  discount  has  the  significance  of  a  deduction  from  the  cost 
of  supplies,  as  was  explained  in  Chapter  IV. 

3.  If  the  above  mentioned  account  were  settled  with  a  thirty- 
day,  non-interest  bearing  note  for  $400,  the  entries  would  be : 

Accounts  Payable $400 

(S.  Company) 

Notes  Payable $400 

The  Notes  Payable  account  is  often  used  to  represent  not  only 
promissory  notes  but  accepted  drafts  and  bills  of  exchange  drawn 
against  the  firm.  Such  instruments  often  draw  interest  at  a 
specified  rate.  The  following  transactions  illustrate  happenings 
involving  the  Notes  Payable  and  Interest  accounts  : 


FURTHER  CLASSIFICATION  OF  EQUITY  ACCOUNTS      149 

1.  A  sixty-day,  six  per  cent  note  for  $500  standing  against  the 
firm  is  paid  at  the  date  of  maturity,  with  interest.     The  interest, 
a  deduction  from  net  revenue,  would  amount  to  $5  in  this  case. 
Accordingly  the  entries  would  be: 

Notes  Payable $500 

Interest 5 

Cash $505 

2.  The  A.  B.  Co.  owes  the  Y.  Co.  $500  for  materials  purchased. 
In  full  settlement  of  this  account  the  A.  B.  Co.  assumes  a  note 
in  favor  of  the  S.  Co.  and  against  the  Y.  Co.     The  face  of  the  note 
is  $490 ;  the  interest  rate  is  six  per  cent ;  the  note  runs  for  three 
months ;   and  the  date  of  assumption  by  the  A.  B.  Co.  is  thirty 
days  prior  to  the  maturity  date.     The  entries  on  the  books  of 
the  A.  B.  Co.  at  the  time  the  note  is  assumed  would  be  as  follows : 

Accounts  Payable $500 

Notes  Payable $490 

Interest  Payable 4.00 

Purchase  Discounts .  ,      5.10 

These  entries  recognize  a  subtraction  from  one  liability,  accounts 
payable,  of  $500,  an  addition  to  another  liability,  notes  payable, 
of  $490,  and  an  addition  to  still  another  liability,  interest  payable, 
of  $4.90  (two  months'  accrued  interest  at  six  per  cent).  The 
difference  between  the  book  value  of  the  new  liabilities  and  that 
of  the  obligation  retired  is  an  allowance  having  the  same  signifi- 
cance as  any  purchase  discount. 

3.  At  the  date  of  maturity  the  A.  B.  Co.  pays  the  note  de- 
scribed in  (2)  with  three  months'  interest,  $7.35.     The  entries 
at  this  time  would  be : 

Notes  Payable $490 

Interest  Payable 4.90 

Interest 2.45 

Cash  .    .    .  - $497-35 

Other  transactions  involving  promissory  notes  and  interest 
and  discount  calculations  and  entries  will  be  given  in  a  later 
chapter. 


150  PRINCIPLES  OF  ACCOUNTING 

b.  Another  group  of  accounts  with  current  liabilities  are  those 
representing  accrued  items.  The  account,  Interest  Payable, 
shown  in  the  above  entries,  is  an  illustration.  Other  examples 
are  Wages  Payable,  Taxes  Payable,  and  Rent  Payable.  These 
accounts  represent  rights  of  a  still  more  transitory  character. 
Such  rights  arise  largely  because  of  the  familiar  fact  that  the 
typical  business  enterprise  utilizes  services  a  few  days  or  weeks 
in  advance  of  payment  for  the  same.  Since  such  items  are  not 
recognized  in  the  accounts  except  at  the  closing  periods  the 
treatment  of  these  accrued  liabilities  in  the  accounts  will  be  given 
in  the  next  chapter. 


VIII 

CLOSING  AND  INTERPRETING  THE  ACCOUNTS 

As  the  operation  of  an  enterprise  proceeds,  the  various  business 
transactions  occurring  will  be  journalized  and  recorded  in  the 
accounts  according  to  the  principles  developed  in  the  preceding 
chapters.  At  certain  regular  times,  however,  the  management 
(and  other  interests)  will  desire  summary  information  concerning 
the  firm's  financial  position  and  the  events  of  the  operating 
period  just  past.  To  furnish  such  information  it  is  necessary  to 
"close  the  books,"  and  to  prepare  systematic  statements  ex- 
hibiting (i)  the  present  status  of  the  business  and  (2)  the  process 
by  which  this  momentary  condition  is  immediately  attained. 
Although  several  references  to  closing  and  adjusting  entries  have 
been  made  in  the  preceding  pages,  no  specific  discussion  of  this 
important  topic  has  been  presented  thus  far  in  the  text.  In  the 
present  chapter  the  technical  process  of  making  such  entries  and 
closing  the  accounts  will  be  described ;  and  typical  problems  of 
interpretation  that  arise  in  this  connection  will  be  considered. 
The  significance  and  preparation  of  the  important  financial  state- 
ments will  be  discussed  in  Chapter  IX. 

THE    TRIAL   BALANCE 

The  first  step  in  the  process  of  closing  the  accounts  is  the  taking 
of  a  trial  balance.  If  the  books  have  been  properly  kept  by  the 
double-entry  system  in  any  case  there  has  been  an  equal  debit 
entry  (or  entries)  for  every  credit  entry  (or  entries)  and  vice 
versa,  as  already  explained.  Consequently  the  total  of  all  debits 
from  the  general  ledger  accounts  should  equal  the  total  of  all 
credits  from  these  accounts.  If  this  condition  is  found  to  exist 
the  accounts  are  said  to  be  "  in  balance,"  and  it  is  then  assumed 
that  the  bookkeeping  work  has  been  correctly  performed.  It  is 


152 


PRINCIPLES  OF  ACCOUNTING 


in  part  to  test  this  relation  between  aggregate  debit  and  credit 
entries  that  the  periodic  trial  balance  is  "struck."  The  trial 
balance  is  simply  a  summary  transcript  of  the  general  ledger 
which  shows  total  debits  and  total  credits  by  "open"  accounts 
(or  debit  balances  and  credit  balances). 
The  following  table  illustrates  such  a  statement : 

TRIAL  BALANCE  OF  THE  A.  B.  Co., 

August  31,  1918  l 


LEDGER 
PAGE 

NAME  OF  ACCOUNT 

DR. 

CR. 

2 

Real  Estate 

$  40,000 

$ 

3 

Buildings 

70,000 

4 

Equipment 

24,000 

5 

Materials 

120,600 

8 

Cash 

57,900 

31,700 

16 

Accounts  Receivable 

24,800 

13,800 

18 

Notes  Receivable 

8,500 

5,600 

21 

Securities  Owned 

5,000 

I,OOO 

23 

Labor 

8,540 

26 

Fuel 

600 

28 

Insurance 

250 

29 

Miscellaneous  Supplies  and  Services 

800 

36 

Sales  Discounts 

2,100 

38 

Purchase  Discounts 

1,900 

40 

Sales 

76,400 

45 

Rent 

300 

47 

Commercial  Interest 

70 

30 

65 

Capital  Stock 

170,000 

67 

Bonds 

40,000  f 

68 

Notes  Payable 

6,300 

15,000 

75 

Accounts  Payable 

11,200 

24,930 

$380,660 

$380,660 

It  is  the  function  of  the  trial  balance  to  furnish  a  test  for  cleri- 
cal accuracy  and  to  provide  a  convenient  basis  for  the  prepara- 

1  It  should  be  noticed  that  this  statement  represents  a  purely  hypothetical  case. 
The  accounts  given  do  not  conform  to  any  satisfactory  classifications  for  an  actual 
business  enterprise.  They  have  been  selected  rather  because  they  will  serve  as 
convenient  illustrations  in  the  discussion  of  the  important  questions  of  technique 
and  interpretation  that  arise  in  the  process  of  closing  the  accounts. 


CLOSING  AND  INTERPRETING  ACCOUNTS  153 

tion  of  the  financial  statements.  Only  the  open  ledger  accounts 
are  collected  in  such  a  statement,  for  any  accounts  which  exactly 
balance  obviously  need  not  be  included.  A  single  general  ledger 
account,  however,  will  normally  show  either  a  debit  or  credit 
excess.  That  is,  while  the  aggregate  of  the  debit  entries  in  all 
the  accounts  should  equal  the  aggregate  of  credit  entries  in  all 
accounts,  a  particular  account  usually  presents  a  preponderance 
in  one  direction  or  the  other.  The  nature  of  the  account  in  any 
case  determines  which  side  will  commonly  show  this  balance. 
These  net  debit  or  credit  balances  may  be  carried  to  the  trial 
balance,  or  total  debits  and  total  credits,  as  in  the  statement 
shown  above.  The  latter  procedure  is  probably  the  better,  be- 
cause a  trial  balance  so  constructed  can  be  more  easily  interpreted 
than  one  which  shows  net  balances  only.  If  the  totals  from 
both  debit  and  credit  columns  are  used  the  bookkeeper's  pencil 
footings,  without  combination,  are  carried  to  the  trial  balance. 

The  fact  that  the  trial  balance  " proves"  is  not  a  positive  proof 
of  accounting  accuracy,  but  only  a  fairly  reliable  indication. 
There  is  a  chance  that  the  same  error  has  been  made  on  both 
sides  of  the  ledger.  Further,  this  test  cannot  prevent  errors  in 
principle,  or  careless  classification  of  the  items  involved  in  par- 
ticular transactions.  In  recording  the  sale  of  merchandise  for 
cash,  for  example,  the  bookkeeper  may  have  charged  Accounts 
Receivable  instead  of  Cash ;  yet,  as  long  as  the  amounts  were 
correctly  stated,  the  ledger  would  still  be  in  balance.  If  the  trial 
balance  proves,  however,  it  does  show  that  there  has  been  posted 
an  equal  debit  entry  (or  entries)  for  every  credit  entry  (or  entries) 
and  vice  versa. 

Although  the  trial  balance  is  in  principle  a  very  simple  device 
the  actual  process  of  taking  such  a  statement  is  a  matter  of  some 
clerical  difficulty  —  particularly  for  beginners.  It  is  easy  to 
make  small  errors  in  computation  and  interpretation.  Where 
special  books  such  as  the  cash  book  are  used,  which  combine  a 
form  of  journal  with  one  or  more  accounts,  the  accounts  in  these 
books  —  in  so  far  as  they  do  not  appear  in  the  general  ledger  — 
must  be  included.  Further,  it  must  be  remembered  that  where 
controlling  accounts  are  used,  the  controlling  accounts  and  not 
the  subsidiary  accounts  appear  in  the  trial  balance,  though  when 
preparing  a  trial  balance  the  bookkeeper  usually  makes  sched- 


154  PRINCIPLES  OF  ACCOUNTING 

ules  from  the  subsidiary  ledgers  and  checks  the  amounts  appear- 
ing in  the  controlling  accounts  from  these  schedules. 

The  arrangement  of  the  accounts  in  the  trial  balance  is  not  a 
matter  of  great  importance.  Usually  this  statement  is  prepared 
by  following  the  ledger,  page  by  page.  Whatever  scheme  of 
classification  —  alphabetical  or  otherwise  —  that  has  been 
adopted  in  the  ledger,  therefore,  will  be  duplicated  in  the  trial 
balance.  In  the  important  financial  statements  which  are  pre- 
pared after  the  process  of  closing  is  complete,  however,  other 
bases  of  classification  should  be  followed. 


THE  NECESSITY   FOR   INVENTORY  AND  APPRAISAL 

The  question  now  arises  as  to  whether  the  trial  balance  — 
which  is  a  summary  of  the  ledger  accounts  —  shows  the  financial 
condition  of  the  business  at  a  given  moment  of  time.  This 
question  must  be  answered  in  the  negative ;  and  the  explanation 
of  this  answer  will  serve  to  emphasize  the  fact  already  frequently 
referred  to  that  the  part  played  by  the  regular  work  of  the  book- 
keeper in  furnishing  the  data  of  the  business  process  has  very 
definite  limitations.  Purchase  and  sale  transactions,  and  other 
actual  business  transfers  and  exchanges  are,  for  the  most  part, 
recorded  on  the  books  as  they  occur.  Expense  and  revenue 
accruals,  however,  are  rarely  so  recorded.  Such  value  changes 
are  only  recognized  periodically  when  the  accounts  are  closed  and 
statements  are  prepared.  At  the  moment  the  trial  balance  is 
taken,  therefore,  the  ledger  does  not  represent  the  exact  status 
of  the  enterprise.  It  shows  at  this  time  simply  a  classification 
of  the  debit  and  credit  entries  posted  by  the  bookkeeper  to  cover 
actual  "business"  transactions. 

In  the  case  of  the  typical  enterprise,  as  already  explained,  it 
would  not  be  expedient  to  attempt  to  record  expense  and  revenue 
accruals  in  the  accounts  as  they  occur.  It  would  be  altogether 
too  laborious  and  complicated  a  process  as  a  rule  to  try  to  show 
in  the  Fuel  account  the  subtractions  due  to  the  hourly  or  daily 
consumption  of  coal,  for  example.  The  more  permanent  prop- 
erty equipment  is  no  doubt  depreciating  continuously ;  but  it 
would  not  be  feasible  to  present  this  fact  continuously  in  the 
accounts.  Thus  the  accounts  do  not  show,  currently,  the  ex- 


CLOSING  AND   INTERPRETING  ACCOUNTS  155 

pirations  of  assets  due  to  the  conditions  of  operation  and  the 
passage  of  time.  The  necessity  arises  for  the  inventory  and  ap- 
praisal. If  some  of  the  subtractions  from  assets  are  not  im- 
mediately recorded  in  the  accounts,  inventories  must  be  taken  to 
determine  the  amount  of  each  type  of  property  actually  on  hand, 
and,  consequently,  the  amount  that  has  expired  in  any  case. 
This  sort  of  information  is  always  necessary  to  supplement  and 
correct  the  book  records. 

Further,  current  services  and  commodities  are  often  received 
and  utilized  in  one  accounting  period  although  payment  is  made 
in  a  succeeding  period.  In  such  a  case  it  is  evident  that  there 
will  usually  be  no  entries  in  the  accounts  representing  these  ex- 
pired items  for  which  payment  has  not  yet  been  made.  If  the 
operating  sheet  is  to  cover  all  changes  which  have  actually  oc- 
curred within  a  given  period,  it  will  be  necessary  to  recognize 
such  accrued  expense  charges. 

Similarly  the  actual  amount  of  revenue  that  has  accrued  (that 
is,  that  has  been  earned]  within  a  particular  period  may  not  be 
shown  concurrently  in  the  accounts.  A  firm,  for  example,  owns 
some  bonds  in  another  enterprise  on  which  interest  is  payable 
every  six  months.  The  regular  time  for  closing  the  accounts, 
it  will  be  assumed,  is  two  months  before  the  interest  payment 
date.  It  will  be  necessary,  therefore,  in  closing  the  accounts,  to 
"accrue"  the  interest  for  four  months. 

It  is  evident  that  the  net  change  in  the  equities,  net  revenue, 
cannot  be  determined  until  all  accruals  are  taken  into  considera- 
tion. The  amount  of  merchandise  sales,  for  example,  may  rep- 
resent gross  revenue ;  but  until  all  subtractions  from  assets  have 
been  charged  to  expense  as  a  deduction  from  this  figure  the  actual 
increase  (or  decrease)  in  the  equities  cannot  be  ascertained. 
The  taking  of  inventories  is  therefore  a  matter  of  the  utmost  im- 
portance. 

The  shorter  the  accounting  period  the  more  closely  the  accounts 
will  follow  the  actual  situation.  In  general  the  year  is  the  most 
significant  fiscal  period ;  and  certainly  the  inventories  should  be 
taken  and  the  accounts  closed  at  least  once  each  year.  Some 
enterprises  —  for  example,  the  railways  —  close  their  accounts 
and  prepare  statements  once  a  month.  This  is  a  desirable  pro- 
cedure for  managerial  purposes.  In  the  case  of  a  bus'ness  sub- 


156  PRINCIPLES  OF  ACCOUNTING 

ject  to  seasonal  fluctuations,  however,  the  yearly  statements  fur- 
nish the  most  important  general  information. 

The  problems  of  valuation  that  arise  in  the  actual  process  of 
taking  inventories  are  many  and  difficult.  The  values  of  fixed 
assets  such  as  buildings  must  be  determined  by  appraisals;  and, 
in  view  of  the  many  factors  affecting  the  values  of  these  assets, 
the  appraisals  are  often  very  difficult.  Technical  skill  and 
knowledge  of  business  conditions  must  be  called  into  play  in  the 
appraisement  of  complex  types  of  fixed  assets.  In  the  case  of 
current  assets  such  as  raw  materials,  methods  of  enumeration 
and  measurement  can  be  followed  to  secure  the  physical  inventory. 
The  number  of  units  multiplied  by  the  value  per  unit  gives  the 
value  inventory.  The  values  of  current  rights  such  as  notes  and 
accounts  receivable  are  determined  by  estimation.  The  integrity 
of  the  parties  involved  is  the  decisive  factor  in  making  such 
estimates.  In  the  case  of  contractual  accruals  of  rent  and  in- 
terest, the  inventory  figures  are  furnished  by  computations  based 
upon  a  proper  analysis  of  the  relations  involved.  In  the  case 
of  both  fixed  and  current  assets  there  is  the  added  difficulty  of 
determining  a  proper  basis  for  valuation.  Inventories  may  be 
based  on  either  original  cost,  cost  of  replacement,  present  value 
to  a  "  going  concern,"  or  liquidating  or  market  value.  This 
problem,  which  is  the  essential  theoretical  consideration  involved 
in  valuations,  will  be  discussed  in  Chapter  XX. 

It  is  sometimes  feasible  in  the  case  of  materials,  supplies,  and 
similar  assets  to  keep  a  perpetual  inventory  of  the  stock  on  hand. 
If  materials  placed  in  process  are  taken  from  the  storeroom  only 
upon  properly  authorized  requisitions,  an  entry  may  be  made  in 
the  Materials  account  each  day  to  show  the  amount  of  materials 
transferred  to  Goods  in  Process.  Even  if  a  perpetual  physical 
inventory  is  kept  in  the  stock  records,  however,  it  is  not  always 
practicable  to  attempt  to  recognize  in  the  ledger  accounts  the 
changes  caused  by  such  a  continuous  shifting  of  assets. 

In  this  chapter  attention  will  be  given  primarily  to  the  actual 
process  of  closing  the  accounts,  assuming  the  inventories  to  have 
been  properly  taken. 


CLOSING  AND  INTERPRETING  ACCOUNTS 


157 


CLOSING  ACCOUNTS   WITH  FIXED  ASSETS 

As  an  illustration  of  the  process  of  closing  the  accounts  with 
fixed  assets  the  Buildings  account  will  be  first  considered.  In  the 
illustrative  trial  balance  given  in  a  preceding  section  this  account 
shows  a  debit  balance  of  $70,000  on  August  3ist.  Assuming 
the  accounting  period  in  this  case  to  be  a  month,  this  balance 
represents  the  value  of  this  asset  at  the  beginning  of  the  month 
of  August  plus  any  additions  made  during  the  month,  less  any 
subtractions  for  the  period.  Since  total  debits  and  total  credits 
are  shown  in  this  trial  balance  it  is  evident  that  in  the  case  of 
Buildings  no  subtractions  from  any  cause  whatever  have  been 
recorded  during  August.  The  management  now  decides,  it  may 
be  assumed,  that  the  buildings  have  declined  in  value  during  the 
month  because  of  various  causes  one-half  of  one  per  cent ;  that 
is,  an  appraisal  would  now  show  a  value  of  ninety-nine  and  one- 
half  per  cent  of  book  value,  or  $69,650.  The  expiration  of  prop- 
erty, therefore,  or  the  depreciation  expense  as  far  as  this  asset  is 
concerned,  amounts  to  $350.  It  is  this  latter  amount  that  must 
now  be  subtracted  from  the  asset  account  and  be  carried  to  an 
expense  account.  Assuming  that  the  Buildings  account  is  cred- 
ited directly  with  this  subtraction,  this  account,  closed,  would 
appear  as  follows : 

BUILDINGS 


1918 

1918 

Aug.  i 

J2 

70,000 

Aug.  31 

J96 

350 

Inventory 

V 

69,650 

Inventory 

70,000 

70,000 

Sept.  i 

V 

69,650 

The  amounts  entered  on  the  right-hand  side  of  this  account 
represent  the  closing  computation.  The  credit  of  $350  to  Build- 
ings represents  a  definite  subtraction  from  an  asset  and  requires 
a  concurrent  charge  to  an  expense  account.  This  transaction 
would,  accordingly,  be  represented  by  a  journal  entry.  The  right- 
hand  inventory  figure,  however,  is  not  a  subtraction  but  a  bal- 
ancing entry.  (It  is  assumed  that  the  enterprise  in  this  case  has 


158  PRINCIPLES  OF  ACCOUNTING 

been  in  operation  for  only  one  month.  This  accounts  for  the 
reference  to  a  journal  page  opposite  the  first  left-hand  entry  in 
the  above  account.  This  $70,000  figure  then  represents  the 
charge  to  Buildings  made  when  the  account  was  opened.  There 
have  evidently  been  no  purchases  or  other  additions  during  the 
month.) 

It  is  a  desirable  procedure  to  balance  every  account  at  the  end 
of  each  accounting  period  so  as  to  mark  the  separation  of  the 
periods  sharply,  and  to  show  definitely  the  current  status  of  each 
item.  In  bookkeeping  practice  a  balance  is  taken  by  adding  the 
amount  of  the  balance  in  each  case  to  the  opposite  side  of  the 
account.  In  this  way  actual  subtraction  —  in  the  accounts  at 
any  rate  —  is  avoided.  The  left-hand  inventory  figure  cancels 
the  fictitious  entry  on  the  opposite  side,  and  shows  the  actual 
balance  on  hand,  September  ist.  Since  these  inventory  entries 
have  no  effect  upon  Buildings  or  any  other  account  they  do  not 
represent  a  transaction  and  therefore  need  not  be  journalized. 

In  theory  the  closing  entries  must  be  made  and  posted  before 
the  account  is  balanced.  If  a  special  account,  Depreciation 
Expense,  were  now  opened  these  entries  would  be  as  follows : 

Depreciation  Expense $350 

Buildings $350 

Or  a  still  more  highly  specialized  expense  account,  Depreciation 
of  Buildings,  might  be  charged  instead  of  Depreciation  Expense. 
A  valuation  account,  Allowance  for  Depreciation,  might  be 
credited  with  the  asset  subtraction  instead  of  Buildings,  as  ex- 
plained in  a  preceding  chapter,  if  for  any  reason  it  is  desired  to 
maintain  original  or  cost  figures  in  the  Buildings  account.  In 
this  case  Buildings  would  be  closed  simply  by  balancing,  and 
would  show  September  ist,  as  before,  a  balance  of  $70,000.  Al- 
lowance for  Depreciation  (or  Allowance  for  Depreciation  of  Build- 
ings) would  show  at  this  time  a  credit  balance  of  $350.  The  two 
accounts,  taken  together,  give  the  net  value  of  the  asset,  build- 
ings. The  point  should  be  emphasized  again  that  the  charge  to 
an  expense  account  is  the  same  in  either  case  —  whether  Build- 
ings or  a  subsidiary  valuation  account  be  credited.  The  expense 
account  that  is  used  must  in  its  turn  be  closed.  The  closing  of 
such  accounts  will  be  explained  in  a  later  section  of  the  chapter 


CLOSING  AND   INTERPRETING  ACCOUNTS 


159 


Occasionally  the  estimated  value  of  a  fixed  asset  at  the  end  of 
an  accounting  period  just  equals  the  book  value  —  that  is,  the 
value  appearing  in  the  asset  account  (assuming  there  is  no  valu- 
ation account)  at  the  time  the  new  inventory  is  taken.  In  the 
case  of  the  Real  Estate  account  given  in  the  above  trial  balance 
of  the  A.  B.  Co.  for  example,  the  book  value  or  debit  balance  is 
$40,000.  Assuming  that  an  appraisal  of  the  real  estate  shows 
its  value  to  remain  unchanged  at  $40,000,  it  is  evident  that 
neither  expense  nor  revenue  is  involved  in  the  operating  period 
just  past  as  far  as  this  asset  is  concerned.  The  Real  Estate  ac- 
count woulo},  therefore,  be  closed  simply  by  balancing,  no  jour- 
nal entries  being  required,  thus  : 

REAL  ESTATE 


1918 
Aug.  i 

Inventory 

J3 

40,000 

1918 

Aug.  31 

Inventory 

V 

40,000 

40,000 

40,000 

Sept.  i 

V 

40,000 

The  only  advantage  of  an  actual  closing  of  the  account  in  this 
case  is  that  it  shows  that  a  new  inventory  has  been  taken  and 
that  the  estimated  value  of  this  asset  on  September  ist  is  the 
same  as  the  book  value  August  ist.  The  bookkeeper's  habit 
of  leaving  accounts  with  a  single  entry  unchanged  as  regards 
dates  for  several  periods  should  be  avoided.  Accounts  such  as 
Cash,  from  which  neither  expense  nor  revenue  is  ordinarily  com- 
puted, are  similarly  closed  by  simply  adding  both  sides  and  strik- 
ing a  balance. 

All  accounts  which  represent  the  more  permanent  property 
items  are  closed  as  shown  in  the  above  cases.  From  the  nature 
of  the  fixed  assets  it  follows  that  normally  the  variation  in  value 
for  a  single  period  will  be  slight  relative  to  the  total  amount  ap- 
pearing in  the  asset  account.  Usually,  however,  some  change 
occurs;  and  if  the  policy  of  keeping  the  accounts  "up  to  date" 
is  observed,  these  variations  will  be  recognized  at  the  end  of  each 
period. 


160  PRINCIPLES  OF  ACCOUNTING 

MATERIALS,    SALES  AND   SUBSIDIARY   ACCOUNTS 

In  the  typical  manufacturing  enterprise  the  cost  of  the  mate- 
rials used  in  production  during  a  given  period  constitutes  a  major 
item  of  expense ;  the  amount  of  the  sales  of  finished  goods  rep- 
resents the  principal  revenue.  Similarly,  in  the  case  of  a  retail 
or  other  trading  company,  the  amount  of  merchandise  sales  for 
the  accounting  period  is  the  most  important  gross  income,  and 
the  cost  of  merchandise  used  is  a  large  (usually  the  largest)  de- 
duction. The  computation  of  these  amounts  in  any  case,  and 
the  closing  of  the  various  accounts  involved,  is  an,  important, 
and  somewhat  difficult,  part  of  the  bookkeeper's  work.  In  this 
section  the  process  of  closing  Materials,  Sales  and  subsidiary 
accounts  will  be  discussed. 

For  an  illustration  it  will  be  convenient  to  refer  again  to  the 
trial  balance  given  on  a  preceding  page.  This  trial  balance,  as 
already  explained,  is  supposed  to  represent  the  condition  of  the 
general  ledger  of  the  A.  B.  Co.  on  August  3ist.  Further,  it  will 
be  assumed  as  before  that  this  company  has  been  in  operation 
for  a  single  month.  This  accounts  for  the  fact  that  although 
the  accounts  Materials  and  Sales  appear  in  the  trial  balance 
there  are  no  subsidiary  accounts  such  as  Goods  in  Process  or 
Finished  Goods  in  this  statement.  The  Materials  account  at 
this  time  shows  a  debit  balance  of  $120,600.  Since  total  debits 
and  total  credits  are  shown  in  this  trial  balance  it  is  evident  that 
no  credits  have  been  entered  in  this  account  during  August. 
This  balance,  therefore,  represents  the  value  of  raw  materials 
on  hand  at  the  beginning  of  the  month  plus  the  amount  of  any 
purchases  (or  other  additions)  made  during  the  period.  This 
means  that  no  record  has  been  kept  in  the  accounts  of  materials 
which  have  passed  on  in  the  process  of  production.  All  purchases 
have  been  charged  to  the  Materials  account  as  made,  and  all 
sales  of  finished  goods  have  been  credited  to  Sales.  But  the  ac- 
counts do  not  show  the  value  of  finished  goods  on  hand  or  of 
goods  in  process,  or  the  amount  of  raw  materials  still  in  the  store- 
room. In  order  to  close  these  accounts,  therefore,  and  bring  the 
books  up  to  date,  it  will  be  necessary  first  to  take  inventories  to 
determine  these  facts. 

An  inventory  on  August  3ist,  it  will  be  assumed,  discloses  the 


CLOSING  AND   INTERPRETING  ACCOUNTS 


161 


following  data :  (i)  the  value  of  all  materials  now  in  the  store- 
room is  $40,000 ;  (2)  goods  in  the  shop  in  various  stages  of  manu- 
facture are  valued  at  $8,000 ;  and  (3)  finished  goods  in  the  ware- 
house are  estimated  at  $12,000.  It  will  now  be  necessary  to 
open  several  new  accounts.  A  Goods  in  Process  account  should 
be  charged  with  the  value  of  semi-manufactured  goods.  An  ac- 
count, Finished  Goods,  should  be  debited  with  the  value  of  the, 
completed  product  on  hand.  It  will  also  be  convenient  to  open 
a  special  summary  account,  Trading,  which  may  be  used  to  show 
all  adjustments  of  the  sales  total  and  the  cost  of  materials. 

The  following  exhibits  show  all  of  these  accounts,  including 
Materials  and  Sales,  as  they  would  appear  when  closed. 

MATERIALS  1 


1918 
Aug.  i 
3i 

Inventory 

J4 
P.B.6 

80,000 
40,600 

1918 
Aug.  31 

To  Trading 
Inventory 

J96 

V 

80,600 
40,000 

120,600 

120,600 

Sept.  i 

V 

40,000 

GOODS  IN  PROCESS 


1918 
Aug.  31 

To  Trading 
Inventory 

J96 

8,000 

1918 
Aug.  31 

Inventory 

V 

8,000 

8,000 

8,000 

'Sept.  i 

V 

cS,ooo 

1  When  the  accounts  are  closed  by  means  of  journal  entries  no  explanation  in  the 
ledger  is  necessary  other  than  a  reference  to  the  journal  page  on  which  the  details 
of  the  transaction  may  be  found.  In  each  of  the  illustrations  given  in  this  section, 
however,  the  name  of  the  account  which  is  concurrently  charged  or  credited  as  the 
case  may  be  is  shown  opposite  the  closing  entry.  In  some  cases  ledger  accounts 
are  closed  without  actual  journal  entries.  That  is,  the  closing  amounts  are  trans- 
ferred directly  from  account  to  account  by  the  bookkeeper,  and  no  entries  are  made 
in  the  journal.  This  procedure  is  not  desirable,  however.  Closing  transactions 
are  actual  happenings  in  the  accounting  sense,  and  are  usually  of  particular  impor- 

M 


l62 


PRINCIPLES  OF  ACCOUNTING 

FINISHED  GOODS 


1918 
Aug.  31 

To  Trading 
Inventory 

J96 

12,000 

I9l8 

Aug.  31 

Inventory 

V 

12,000 

I2,OOC 

12,000 

Sept.  i 

V 

I2,OOC 

SALES 


1918 
Aug.  31 

To  Trading 

J96 

76,400 

1918 
Aug.  31 

S.B.8 

76,400 

76,400 

76,400 

TRADING 


1918 

1918 

Aug.  31 

From  Materials 

J96 

80,600 

Aug.  31 

From  Goods  in 

Process 

J96 

8,000 

To  Expense  and 

From    Finished 

Revenue 

J96 

15,800 

Goods 

J96 

12,000 

From  Sales 

J96 

76,400 

96,400 

96,400 

The  closing  journal  entries,  evidently,  would  be  as  follows : 

d) 

Trading $80,600 

Materials $80,600 


Goods  in  Process 
Trading 


(2) 


5,000 


5,000 


tance.  The  details  of  these  transactions  should  be  given  in  the  general  journal. 
Probably  the  best  procedure  for  the  bookkeeper  is  the  following:  (i)  make  the 
closing  computations  on  loose  sheets;  then  (2)  make  the  proper  entries  in  the 
journal ;  (3)  post  to  the  accounts  affected ;  and  finally  (4)  balance  the  accounts 
by  making  use  of  the  inventory  amounts. 


CLOSING  AND   INTERPRETING   ACCOUNTS  163 

(3) 

Finished  Goods $12,000 

Trading $12,000 

(4) 

Sales $76,400 

Trading $76,400 

(5) 

Trading $15,800 

Expense  and  Revenue  .     .     .     .     ,  .  $15,800 

It  is  important  that  the  significance  of  these  entries  be  clearly 
recognized.  The  entries  under  (i)  show  the  total  subtraction 
from  materials  made  during  the  month  and  carry  this  subtrac- 
tion to  Trading  as  a  deduction  from  revenue.  But  not  all  of 
these  materials  have  been  consumed  in  the  manufacture  of  goods 
sold  during  this  period.  Finished  goods  in  the  warehouse  amount 
to  $12,000,  and  goods  in  process  are  valued  at  $8,000.  If,  then, 
the  value  of  all  materials  taken  from  the  storeroom  is  considered 
as  a  deduction  from  revenue  it  is  necessary  to  offset  this  deduc- 
tion with  the  goods  in  process  and  finished  goods  amounts.  One 
method  of  making  such  adjustments  is  shown  in  the  entries 
under  (2)  and  (3)  above.  The  credits  to  Trading  in  these  cases 
represent  not  revenues  but  offsets  to  overstated  costs.  The 
concurrent  charges  to  Goods  in  Process  and  Finished  Goods  recog- 
nize the  asset  balances  in  these  accounts. 

The  gross  revenue  shown  by  the  Sales  account  is  transferred 
to  Trading  by  the  entries  under  (4).  The  balance  of  Trading, 
$15,800,  is  now  carried  to  Expense  and  Revenue.  This  latter 
account  is  a  summary  computation  account  —  often  called 
Profit  and  Loss  —  to  which  is  carried  the  net  balance  of  the 
materials  and  merchandise  accounts  and  all  other  expense  and 
revenue  balances.  (The  nature  and  use  of  such  an  account  will 
be  further  explained  in  a  later  section.)  It  is  evident  that  the 
balance  of  the  Trading  account  is  not  net  revenue,  but  simply 
sales  less  certain  important  elements  of  total  cost  or  expense. 

The  entries  and  accounts  shown  in  the  above  case  illustrate 
the  general  characteristics  of  the  process  of  combining  gross 
revenues  and  material  costs  at  the  end  of  the  accounting  period. 
Many  variations  in  this  procedure,  however,  are  possible.  The 


1 64  PRINCIPLES  OF  ACCOUNTING 

total  subtraction  from  materials,  for  example,  might  be  first 
charged  to  Goods  in  Process  rather  than  to  Trading.  After 
making  the  inventory  adjustment  the  balance  of  the  Goods  in 
Process  account  could  be  closed  into  Finished  Goods.  The 
balance  of  this  latter  account,  in  turn,  might  then  be  transferred 
to  Trading.  If  the  results  of  a  daily  inventory  of  materials  were 
recorded  in  the  accounts  this  procedure  would  be  particularly 
desirable.  Another  variation  would  involve  the  elimination  of 
the  Trading  account.  In  this  event  Materials,  Goods  in  Process, 
Finished  Goods  and  Sales  might  be  closed  directly  into  an  Ex- 
pense and  Revenue  account. 

The  adjustments  of  gross  revenue  and  cost  of  materials  in  the 
typical  case  are  usually  more  numerous  than  as  shown  by  the 
above  entries.  An  account  is  often  kept,  for  example,  to  show 
the  amount  of  defective  or  otherwise  unsatisfactory  materials 
returned.  The  nature  of  such  an  account  can  be  shown  by  a 
definite  illustration.  A  certain  company  buys  materials  on  ac- 
count amounting  to  $1,000.  The  entries  (in  the  general  ledger 
accounts)  would  be : 

Materials $1,000 

Accounts  Payable $1,000 

Of  this  shipment  materials  amounting  to  $200  are  found  to  be  of 
another  type  than  that  ordered,  and  are  accordingly  returned  as 
unsatisfactory.  The  selling  company  allows  the  buying  company 
credit  on  its  books  for  the  full  amount  of  materials  returned.  The 
entries  on  the  buying  company's  books  would  therefore  be : 

Accounts  Payable. $200 

Materials  Returned $200 

The  balance  of  the  Materials  Returned  account  at  the  end  of  the 
period  ($500,  it  will  be  assumed)  may  be  closed  into  Materials 
by  the  following  entries : 

Materials  Returned $500 

Materials $500 

Or  the  balance  of  this  account  might  be  carried  directly  to 
Trading. 


CLOSING  AND  INTERPRETING  ACCOUNTS  165 

Similarly,  returns  of  finished  goods  by  customers  require  an 
adjustment  of  the  gross  revenue  figure  either  by  closing  the 
amount  of  such  returns  into  the  Sales  account  or  by  carrying  this 
amount  directly  to  Trading.  The  following  entries  illustrate  a 
possible  case: 

d) 

Sales  Returns 

Accounts  Receivable 


(2) 

Sales $400 

Sales  Returns 

Rebates  and  allowances  and  other  offsets  and  discounts  re- 
quire similar  adjustments.  All  such  amounts  are  current  valua- 
tion items,  and  the  accounts  with  these  items  must  therefore 
be  closed  at  the  end  of  each  period.  Some  further  attention  will 
be  given  to  this  matter  in  a  later  section  of  this  chapter. 

Thus  far  in  discussing  the  inventories  of  goods  in  process  and 
finished  goods  it  has  been  implied  that  such  amounts  are  of  par- 
ticular importance  because  of  their  influence  on  the  cost-of-mate- 
rials  figure  for  a  given  period.  This  is  a  proper  implication,  but 
except  in  cases  where  the  element  of  manufacture  is  entirely 
absent  or  negligible  it  is  not  the  whole  story.  It  should  be  recog- 
nized that  such  adjustments  also  prevent  the  over-  or  under- 
statement of  other  expenses  for  the  period.  All  charges  for  com- 
modities and  services  expired  are  in  part  applicable  to  goods  in 
process  and  finished  goods  on  hand.  In  other  words  a  part  of  the 
total  of  all  asset  expirations  for  a  particular  period  is  represented 
in  the  value  of  goods  in  process  and  finished  goods.  In  some 
cases  the  element  of  manufacture  may  be  more  significant  than 
the  element  of  raw  materials,  for  such  items  as  labor  services 
consumed,  fuel  burned,  the  depreciation  of  factory  building,  etc., 
may  contribute  more  to  the  value  of  finished  goods  than  the  cost 
of  the  materials  utilized  in  their  production. 

It  is  evident  in  the  above  case  of  the  A.  B.  Co.,  for  example, 
that  if  all  asset  expirations  are  treated  as  deductions  from  August 
revenues,  other  expenses  than  materials  will  be  overstated ;  for 
all  of  these  costs  are  not  applicable  to  goods  sold  during  the  month. 


1 66  PRINCIPLES  OF  ACCOUNTING 

This  is  the  more  apparent  since  this  is  the  first  month  the  com- 
pany has  operated.  If  manufacturing  and  selling  were  to  pro- 
ceed at  exactly  the  same  rate  month  by  month  hereafter,  pay- 
ments for  labor  services  and  all  similar  charges  could  be  considered 
as  deductions  from  revenue  when  made;  that  is,  the  expense 
amounts  would  be  correctly  stated  although  the  incidence  of 
specific  items  would  be  illogical.  But  unless  this  unusual  con- 
dition exists  it  will  be  necessary  to  take  into  consideration  each 
month  the  inventories  of  semi-finished  and  finished  product  in 
order  to  determine  the  expense  and  revenue  totals  properly 
applicable  to  each  period.  At  the  end  of  the  next  period  it  will 
not  be  the  total  inventories  of  goods  in  process  and  finished 
goods  which  the  company's  bookkeeper  must  carry  to  Trading 
or  to  Expense  and  Revenue  as  an  offset  to  overstated  expense 
charges,  but  rather  the  increase  in  these  inventories  over  the 
amounts  determined  on  August  3ist.  If  these  inventories  show 
a  decrease  on  September  3oth  it  will  be  necessary,  analogously, 
to  consider  the  amount  of  the  decrease  an  addition  to  expense ; 
for  otherwise  September's  costs  will  be  understated. 

In  determining  the  value  of  goods  in  process  or  of  finished 
goods,  therefore,  the  problems  of  cost  accounting  are  involved. 
The  total  cost  of  production  —  exclusive  of  selling  expenses  — 
must  be  apportioned  among  the  various  stages  of  manufacture 
and  spread  over  units  of  finished  and  semi-finished  goods.  A 
physical  inventory  gives  the  number  of  units ;  an  analysis  of 
costs  gives  the  value  per  unit.  The  difficult  part  of  the  process, 
evidently,  is  the  allocation  of  costs.  An  account,  Cost  of  Goods 
Sold,  is  often  set  up,  and  is  charged  with  that  part  of  total  expense 
applicable  to  goods  sold  during  the  period.  The  balance  of  total 
cost  incurred  represents  the  value  of  materials,  goods  in  process, 
and  completed  product  on  hand.  Many  subsidiary  accounts 
and  cost  records  are  used  in  the  typical  case.  No  attempt  will 
be  made  here  to  discuss  the  intricacies  of  factory  cost  accounting. 
This  brief  statement,  however,  should  serve  to  suggest  the  nature 
of  the  problem,  and  its  accounting  significance. 

Even  in  the  case  of  a  trading  enterprise,  where  the  element  of 
manufacture  is  entirely  absent,  there  are  certain  costs  which  may 
be  incurred  in  a  particular  period  —  in  addition  to  the  principal 
merchandise  cost  —  which  are  not  entirely  applicable  to  product 


CLOSING  AND   INTERPRETING  ACCOUNTS  167 

sold  during  that  period.  Freight  and  cartage,  and  the  cost  of 
unpacking,  shelving,  and  otherwise  preparing  goods  for  sale 
are  examples  of  such  items.  In  taking  inventories  of  merchandise 
on  hand  it  is  necessary  to  take  such  charges  into  consideration 
if  the  exact  amounts  of  expense  and  revenue  applicable  to  each 
period  are  to  appear  in  the  accounts  of  that  period.  If  purchases 
and  sales  run  fairly  even  month  by  month,  however,  these  items 
can  be  charged  to  expense  as  they  arise  without  serious  error. 
In  discussing  the  process  of  taking  inventories  of  current  assets 
in  a  later  chapter  some  further  attention  will  be  given  to  this 
topic. 


CLOSING  MERCHANDISE   ACCOUNTS 

In  the  case  of  retail  and  other  trading  companies  the  mer- 
chandise accounts  present  certain  special  problems  of  analysis 
at  the  end  of  the  accounting  period  which  should  be  discussed 
at  this  point.  As  explained  in  a  preceding  chapter  Merchandise 
is  sometimes  kept  as  a  mixed  account  —  that  is,  an  account  which 
presents  the  complication  of  combining  specifically  both  asset 
and  equity  elements.  This  case  will  first  be  considered. 

The  Merchandise  account  in  the  trial  balance  of  the  Y.  Co. 
December  3ist,  it  will  be  assumed,  shows  total  debits  of  $122,600 
and  total  credits  of  $56,400.  The  first  total  represents  the  cost 
of  all  merchandise  purchased  during  the  period  just  ended  plus 
the  cost  of  goods  on  hand  at  the  beginning  of  the  period ;  the 
credit  total  shows  the  total  value  of  goods  sold  during  the  period 
at  selling  prices.  An  inventory  at  this  time  shows  goods  on  hand 
to  the  amount  of  $78,600  valued  at  cost.  Then  $122,600  less 
$78,600  gives  $44,000,  the  merchandise  cost  of  the  goods  sold. 
Subtracting  this  figure  from  $56,400  gives  a  difference  of  $12,400, 
the  merchandise  revenue,  or  "gross  trading  profit"  as  it  is  some- 
times called,  for  the  period.1  In  closing  the  Merchandise  account 
the  bookkeeper  shows  this  computation  thus  : 

1  It  should  be  noted  that  the  term  revenue  can  be  applied  with  equal  propriety 
to  total  sales,  or  to  sales  less  merchandise  costs.  There  is  no  fundamental  reason 
for  considering  revenue  in  any  case  to  be  a  balance  remaining  after  a  part  but  not  all 
of  the  total  expense  of  production  has  been  deducted. 


1 68 


PRINCIPLES  OF  ACCOUNTING 


MERCHANDISE 


1917 

1917 

Dec.  i 

Inventory 

V 

82,000 

Dec.  31 

S.B.3 

56,400 

3i 

P.B.s 

40,600 

Inventory 

V 

78,600 

Jss 

12,400 

135,000 

135,000 

1918 

1918 

Jan.  i 

Inventory 

V 

78,600 

This  method  of  closing  illustrates  again  the  bookkeeping  prac- 
tice of  adding  to  the  opposite  side  instead  of  subtracting.  The 
inventory  brought  down  at  the  left  cancels  the  balancing  entry 
on  the  credit  side  and  shows  the  property  balance  on  hand.1 
On  January  ist  the  Merchandise  account  represents  $78,600 
in  property  and  nothing  else.  It  is  convenient  to  think  of  this 
closing  computation  in  the  case  of  Merchandise  or  any  similar 
account  in  the  way  stated  above :  total  debits  less  the  new  in- 
ventory shows  the  cost  of  goods  sold ;  total  credits  less  the  cost 
of  goods  sold  gives  merchandise  revenue.  The  bookkeeper, 
however,  instead  of  using  two  instances  of  subtraction  adds  to 
the  opposite  sides  and  accomplishes  the  same  result. 

If  a  special  Merchandise  Revenue  account  were  now  set  up  to 
show  this  item  of  revenue  the  entries  transferring  the  item  from 
Merchandise  to  Merchandise  Revenue  would  be : 


Merchandise $12,400 


Merchandise  Revenue 


$12,400 


When  this  revenue  is  carried  to  a  general  Expense  and  Revenue 
account  the  following  entries  would  be  made : 


Merchandise  Revenue $12,400 


Expense  and  Revenue 


$12,400 


1  Thinking  of  the  Merchandise  account  on  December  3ist  as  an  expense  and 
revenue  account  there  is  another  way  of  viewing  this  closing  computation.  Since 
the  total  of  the  old  inventory  plus  purchases  is  treated  as  a  deduction  from  sales  it 
is  necessary  to  consider  the  new  inventory  as  a  revenue  item  —  an  addition  to  sales. 


CLOSING  AND   INTERPRETING  ACCOUNTS  169 

If  no  special  Merchandise  Revenue  account  had  been  kept,  the 
item  of  revenue  would  have  been  carried  directly  from  Mer- 
chandise to  Expense  and  Revenue,  thus : 

Merchandise $12,400 

Expense  and  Revenue $12,400 

The  debits  to  Merchandise  in  both  of  these  cases  represent  not 
an  addition  to  the  left-hand  side,  but  a  subtraction  of  the  revenue 
or  equity  element  from  the  right-hand  side ;  that  is,  such  entries 
represent  the  transfer  of  an  item  of  revenue  from  one  account  to 
another. 

The  use  of  such  a  mixed  account  for  small  enterprises  is  entirely 
proper ;  but  the  nature  of  each  of  the  different  phases  of  mer- 
chandise should  be  clearly  recognized.  In  the  retail  trade,  mer- 
chandise as  purchased  is  the  raw  material ;  merchandise  in  the 
hands  of  the  consumer  constitutes  the  finished  product.  The 
element  of  manufacture  is  entirely  absent  and  production  con- 
sists primarily  in  furnishing  place  and  time  utilities.  This  situa- 
tion, however,  should  not  be  allowed  to  obscure  the  fact  that 
production  is  actually  taking  place,  and  that  merchandise  pur- 
chased and  merchandise  sold  belong  to  entirely  distinct  classes 
of  accounting  data.  The  sales  total  represents  gross  revenue; 
the  cost  of  goods  sold  constitutes  the  principal  expense;  mer- 
chandise on  hand  is  often  the  most  important  asset.  A  mer- 
chandise account  such  as  the  one  above,  therefore,  shows  asset, 
expense,  and  revenue  items.  If  these  items  are  listed  in  the 
proper  columns,  however,  and  are  correctly  interpreted,  no  con- 
fusion results  from  the  use  of  such  a  "combination"  account. 

In  the  case  of  a  large  retail  enterprise  it  is  desirable  to  use 
several  accounts  instead  of  one  general  account  —  as  in  the  case 
just  explained  —  to  show  the  various  phases  of  merchandise 
involved.  A  convenient  procedure  is  the  use  of  four  distinct 
accounts  for  this  purpose :  (i)  Merchandise  Inventory ;  (2)  Mer- 
chandise Purchases ;  (3)  Merchandise  Sales  (Revenue) ;  and 
(4)  Merchandise  Cost  (Expense).  At  the  time  the  trial  balance 
is  taken  —  using  the  figures  in  the  above  case  —  (i)  would  show 
a  debit  balance  of  $82,000 ;  (2),  a  debit  balance  of  $40,600 ;  (3),  a 
credit  balance  of  $56,400 ;  and  (4)  would  show  no  entries.  The 


170 


PRINCIPLES  OF  ACCOUNTING 


inventory  is  as  before  $78,600.     What  are  the  entries  necessary 
to  close  these  accounts  ? 

Merchandise  Inventory  shows  a  debit  balance  of  $82,000,  and 
the  present  inventory  is  but  $78,600.  The  procedure  in  closing 
this  account  would  be  similar  to  the  case  of  Buildings  described 
in  a  preceding  section.  Merchandise  as  an  asset  has  declined  in 
value  $3,400.  Of  the  $82,000  listed  in  this  account,  $3,400  has 
expired.  This  transaction  would  be  journalized  as  follows : 


Merchandise  Cost     .... 
Merchandise  Inventory 


,400 


,400 


If  the  new  inventory  had  been  larger  than  the  old,  a  debit  to 
Merchandise  Inventory  and  a  credit  to  Merchandise  Cost  for 
the  amount  of  the  increase  would  be  necessary. 

Merchandise  Purchases  shows  a  debit  balance  of  $40,600. 
This  account  is  not  treated  as  an  asset  account  in  this  case  but  as 
an  expense  account,  the  asset  adjustment,  if  more  or  less  goods 
than  the  amount  purchased  are  sold,  being  made  through  Mer- 
chandise Inventory  as  shown  above.  The  amount  in  this  ac- 
count will  then  be  closed  into  Merchandise  Cost,  thus : 

Merchandise  Cost $40,600 

Merchandise  Purchases     ....  $40,600 

Merchandise  Cost  and  Merchandise  Sales  can  now  be  closed 
into  Expense  and  Revenue  by  the  following  entries : 


Expense  and  Revenue $44,000 

Merchandise  Cost 


and, 


1,000 


Merchandise  Sales $56,400 

Expense  and  Revenue $56,400 


The .  merchandise   accounts,   closed,    would   now    appear   as 

follows : 

MERCHANDISE  INVENTORY 


1917 

1917 

Dec.  i 

Inventory 

V 

82,000 

Dec.  31 

J55 

3,4oo 

Inventory 

V 

78,600 

82,000 

82,000 

1918 

Jan.  i 

Inventory 

V 

78,600 

CLOSING  AND   INTERPRETING  ACCOUNTS  171 

MERCHANDISE  PURCHASES  x 


1917 

Dec.  31 

P.B.5 

40,600 

1917 
Dec.  31 

JSS 

40,600 

40,600 

40,600 

MERCHANDISE  SALES 


1917 

Dec.  31 

Jss 

56,400 

1917 
Dec.  31 

S.B.3 

56,400 

56,400 

56,400 

MERCHANDISE  COST 


1917 

Dec.  31 

Jss 
Jss 

3,400 
40,600 

1917 
Dec.  31 

Jss 

44,000 

44,000 

44,000 

The  Expense  and  Revenue  account  would  now  show  the  fol- 
lowing condition  as  far  as  merchandise  items  are  concerned : 

EXPENSE  AND  REVENUE 


1917 
Dec.  31 

Jss 

44,000 

1917 
Dec.  31 

Jss 

56,400 

The  procedure  just  outlined  is  a  convenient  and  logical  method 
of  handling  the  merchandise  accounts.  In  this  case  merchandise 

1  The  debit  balance  shown  in  this  account  is  intended  to  represent  the  total  of 
all  postings  made  during  the  month ;  and  this  is  true  of  all  the  trial  balance  figures 
used  in  these  illustrations. 


172  PRINCIPLES  OF  ACCOUNTING 

cost  is  carried  to  the  debit  side  of  the  Expense  and  Revenue  ac- 
count ;  and  gross  revenue  from  sales,  before  any  deductions  have 
been  made,  is  carried  to  the  credit  side.  As  was  shown  above, 
however,  it  is  perfectly  possible  to  make  all  these  computations 
in  one  account,  and  to  carry  merchandise  revenue  less  merchan- 
dise cost  from  this  single  account  directly  to  Expense  and  Rev- 
enue. The  chief  reason  for  using  several  accounts  is  the  need 
for  differentiating  sharply  between  departments  and  phases  of 
the  business  for  managerial  purposes.  Further,  where  special 
journals  are  used  this  procedure  connects  the  ledger  accounts 
more  definitely  with  the  books  of  original  entry. 

An  alternative  procedure  is  the  use  of  all  the  accounts  shown 
above  with  the  exception  that  a  computation  account,  Merchan- 
dise Trading,  is  used  instead  of  Merchandise  Cost.  This  ac- 
count is  similar  to  the  Trading  account  discussed  in  the  preceding 
section,  and  is  of  advantage  particularly  in  cases  where  it  is  de- 
sired to  secure  an  intermediate  revenue  figure  before  net  expenses 
have  been  deducted.  Using  a  Merchandise  Trading  account  for 
the  above  case  the  closing  entries  would  be  as  follows  : 

(i) 
Merchandise  Trading     .......      $3,400 

Merchandise  Inventory     ....  $3,400 

which  adjusts  Merchandise  Inventory;   and, 


Merchandise  Trading     .......    $40,600 

Merchandise  Purchases     ....  $40,600 

Merchandise  Sales     ........    $56,400 

Merchandise  Trading    .....  $56,400 

which  close  purchases  and  sales  into  Merchandise  Trading  ;  and, 

(3) 
Merchandise  Trading     .......    $12,400 

Expense  and  Revenue  .....  $12,400 

which  carries  the  item  of  revenue  less  merchandise  cost  into  Ex- 
pense and  Revenue. 

The  Merchandise  Trading  account,  closed,  would  now  stand 
as  follows  : 


CLOSING  AND   INTERPRETING  ACCOUNTS 
MERCHANDISE  TRADING 


173 


1917 

1917 

Dec.  31 

Jss 

3,4oo 

Dec.  31 

Jss 

56,400 

J55 

40,600 

Jss 

12,400 

56,400 

56,400 

A  Merchandise  Trading  account  is  especially  useful  if  it  be 
desired  to  further  adjust  the  merchandise  revenue  item  before 
it  is  carried  to  a  general  Expense  and  Revenue  account.  Dis- 
counts on  purchases  and  sales,  as  explained  in  a  preceding  chap- 
ter, are  valuation  items  which  must  be  used  to  adjust  merchan- 
dise cost  and  merchandise  revenue,  before  the  exact  amount 
of  revenue  is  ascertained.  One  method  of  making  this  adjust- 
ment is  to  close  the  balances  in  the  Purchase  Discounts  and 
Sales  Discounts  accounts  into  Merchandise  Trading.  Using  the 
amounts  appearing  in  the  trial  balance  on  page  152  for  an  illus- 
tration, the  entries  would  be : 


and, 


Merchandise  Trading $2,100 

Sales  Discounts  .  $2,100 


Purchase  Discounts $1,900 

Merchandise  Trading $1,900 


Similarly,  other  allowances  and  rebates  as  well  as  purchase  and 
sales  returns  may  be  set  up  in  special  accounts  which  are  closed 
into  Merchandise  Trading  at  the  end  of  each  period.  The  process 
of  closing  such  accounts  is  similar  to  the  procedure  shown  in  the 
preceding  section  in  connection  with  materials  and  finished  goods 
returned. 

It  is  sometimes  urged  that  other  expenses,  such  as  "in-freight," 
are  costs  of  merchandise,  and  as  such  should  either  be  closed  into 
Merchandise  Purchases  or  Merchandise  Trading.  This  pro- 
cedure is  not  unreasonable,  particularly  where  merchandise  is 
the  most  significant  cost  and  product.  But  arguments  nearly 
as  valid  can  be  made  in  favor  of  closing  all  expense  items  in  such 
cases  into  some  merchandise  account.  And  if  this  were  done  the 


174  PRINCIPLES  OF  ACCOUNTING 

account  in  question  would  simply  become  a  general  Expense  and 
Revenue  account.  It  is  doubtful  if  the  dictates  of  logical  analy- 
sis are  further  satisfied  by  such  adjustments.  Further,  in  most 
cases  no  new  information  of  sufficient  importance  is  furnished  to 
warrant  the  expenditure  of  the  necessary  clerical  effort.  As  sug- 
gested in  the  preceding  section,  however,  the  amount  of  such 
costs  as  in-freight  applicable  to  goods  on  hand  at  the  end  of  a 
period  should  be  considered  in  determining  the  inventory  figure. 

In  the  case  of  a  manufacturing  enterprise,  evidently,  the  Mate- 
rials account  may  be  divided  into  two  accounts,  Materials  In- 
ventory and  Materials  Purchases.  Such  accounts  are  closed  in 
the  same  way  as  the  corresponding  merchandise  accounts  shown 
above.  Where  a  firm  deals  in  several  types  of  merchandise,  or 
requires  several  kinds  of  raw  materials,  a  whole  series  of  these 
accounts  may  be  used.  Similarly  a  distinct  sales  account  may 
be  opened  for  each  important  type  of  product.  The  process  of 
closing  the  accounts  in  such  cases  is  more  complex  than  in  the 
cases  here  discussed,  but  it  would  be  accomplished  in  an  analo- 
gous manner. 

In  discussing  merchandise  inventories  and  merchandise  ex- 
pense and  revenue  items  in  this  section  it  has  been  assumed  for 
convenience  that  no  change  in  cost  prices  has  occurred  during 
the  period  in  question,  and  that  no  value  declines  because  of 
physical  deterioration  or  obsolescence  have  taken  place.  If 
the  inventory  item  used  had  involved  such  changes,  however, 
the  closing  entries  would  have  been  made  in  exactly  the  same 
manner  as  shown  above. 


CLOSING   ACCOUNTS   RECEIVABLE 

Accounts  representing  depreciable  rights  against  other  indi- 
viduals and  firms  are  often  closed  simply  by  balancing,  as  are 
the  equipment  property  accounts,  and  the  expirations  are  re- 
corded in  subsidiary  valuation  accounts.  Accounts  Receivable 
furnishes  an  important  illustration  of  this  procedure. 

In  the  illustrative  trial  balance  appearing  on  page  152  this  ac- 
count shows  total  debits  of  $24,800  and  total  credits  of  $13,800. 
The  debit  total  represents  the  sum  of  the  additions  to  this  kind 
of  property  made  during  August  plus  the  balance  at  the  begin- 


CLOSING  AND  INTERPRETING   ACCOUNTS 


175 


ning  of  the  period.  (If  it  be  assumed,  as  before,  that  the  A.  B. 
Co.  has  been  operating  for  a  single  month  it  is  probable  that 
Accounts  Receivable  had  no  balance  on  August  ist.)  The 
credit  total  shows  the  amount  of  such  claims  paid  during  the 
month.  These  figures  represent  the  totals  of  the  daily  or  weekly 
postings  to  Accounts  Receivable  from  the  sales  book,  cash  book, 
or  other  journal.  At  the  end  of  the  month  this  account  would 
be  closed  by  taking  a  balance,  and  would  then  appear  as  follows  : 

ACCOUNTS  RECEIVABLE 


1918 

1918 

Aug.  31 

S.B.8 

24,800 

Aug.  31 

C.B.4 

10,200 

J97 

3,6oo 

Balance 

V 

11,000 

24,800 

24,800 

Sept.    i 

Balance 

V 

11,000 

The  balance  of  this  account,  however,  is  not  likely  to  represent 
the  actual  value  of  the  outstanding  book  accounts.  In  the  case 
of  nearly  every  business  enterprise  the  customers'  accounts 
which  prove  to  be  entirely  worthless  or  are  not  paid  in  full  amount 
to  a  more  or  less  considerable  fraction  of  the  total  of  such  accounts 
arising  during  a  given  season  or  year.  A  reasonable  allowance, 
therefore,  should  be  made  at  the  end  of  each  accounting  period 
for  the  amount  of  "bad  debts"  applicable  to  the  business  of  that 
period.  If  such  a  deduction  from  revenue  is  not  recorded  in 
each  case  the  accounts  will  not  show  a  net  revenue  figure  based 
upon  the  recognition  of  all  actual  accruals  of  cost  and  income 
within  the  period.  For  an  illustration  of  the  treatment  of  an 
allowance  for  bad  accounts  it  will  be  assumed  that  of  the  balance 
($11,000)  shown  in  the  above  case  three  per  cent,  or  $330,  is  a 
reasonable  estimate  of  the  amount  which  will  prove  uncollectible. 
How  should  this  item  be  recorded  in  the  accounts  ? 

Since  Accounts  Receivable  is  a  controlling  account  for  the 
customers'  ledger  no  deductions  for  estimated  bad  debts  should 
be  shown  directly  in  this  account.  Otherwise  the  totals  of  the 
debit  and  credit  balances  of  the  individual  accounts  in  the  sub- 
sidiary ledger  will  not  equal  the  debit  and  credit  totals  in  Ac- 


176  PRINCIPLES  OF  ACCOUNTING 

counts  Receivable.  The  controlling  account,  therefore,  should 
be  closed  by  balancing  as  shown  above.  It  will  then  be  neces- 
sary to  open  a  valuation  account,  Allowance  for  Uncollectible 
Accounts,  in  which  to  record  the  offset,  or  valuation  item,  of 
$330.  The  journal  entries  would  be  as  follows  : 

Expense  and  Revenue $330 

Allowance  for  Uncollectible  Accounts  .  $330 

(A  special  account,  Uncollectible  Accounts  Expense,  might  be 
charged  with  the  amount  of  this  deduction.  In  this  case  it  would 
be  necessary  finally  to  close  the  subsidiary  expense  account  into 
Expense  and  Revenue.) 

The  charge  to  Expense  and  Revenue  deducts  the  proper  amount 
from  the  revenue  of  the  period,  and  the  credit  to  the  valuation 
account  indicates  the  decline  in  assets.  The  balance  of  Accounts 
Receivable  less  the  balance  now  appearing  in  the  subsidiary 
account  shows  the  estimated  value  of  the  outstanding  book 
accounts. 

The  later  entries  affecting  Allowance  for  Uncollectible  Accounts 
throw  some  light  upon  the  nature  and  use  of  such  a  valuation 
account.  On  August  3ist,  it  may  be  assumed,  A.  Wilson  owes 
the  A.  B.  Co.  $200  on  open  account.  A  few  weeks  later  this 
customer  becomes  bankrupt  and  when  his  estate  is  liquidated 
the  unsecured  creditors  receive  but  ten  cents  on  the  dollar  in 
settlement  of  their  claims.  The  entries  on  the  books  of  the  A.  B. 
Co.  at  this  time  would  be : 

Cash $  20 

Allowance  for  Uncollectible  Accounts  ....      180 

Accounts  Receivable $200 

(A.  Wilson) 

These  entries  recognize  the  retirement  of  a  specific  account  and 
hence  both  the  controlling  account  in  the  general  ledger  and  the 
customer's  personal  account  in  the  subsidiary  ledger  should  be 
credited.  The  difference  between  the  amount  realized  and  the 
face  of  A.  Wilson's  account  is  the  amount  of  the  charge  to  Al- 
lowance for  Uncollectible  Accounts,  This  amount  has  been 
previously  charged  against  revenue,  and  the  subtraction  from  the 
asset  has  been  indicated  by  a  credit  to  the  valuation  account. 


CLOSING  AND  INTERPRETING  ACCOUNTS  177 

Since  a  specific  asset  is  now  being  written  off,  a  credit  directly 
to  the  asset  account  should  be  substituted  for  a  credit  item  in 
the  subsidiary  account.  ;1 

At  the  end  of  an  accounting  period  it  may  be  necessary  to  rec- 
ognize changes  in  the  values  of  other  rights  as  well  as  accounts 
receivable.  In  the  trial  balance  of  the  A.  B.  Co.  Notes  Receiv- 
able shows  a  net  debit  balance  of  $2,900.  If  there  is  good  reason 
for  thinking  that  the  notes  now  held  by  the  company  are  worth 
less  than  this  sum  this  fact  should  be  recognized  in  the  accounts. 
The  amount  of  the  estimated  loss  applicable  to  the  current  period 
should  be  charged  against  the  revenue  of  the  period.  The  sub- 
traction from  assets  may  be  indicated  by  a  credit  to  a  valuation 
account  as  in  the  above  case.  When,  later,  a  specific  note  is 
discovered  to  be  worthless,  Notes  Receivable  would  be  credited 
and  the  valuation  account  debited  for  the  amount  of  the  note. 
In  this  case  it  will  be  assumed  that  the  inventory  figure  is  the 
same  as  the  balance  of  the  Notes  Receivable  account. 

The  account,  Securities  Owned,  appearing  in  the  same  trial 
balance,  represents  still  other  rights  which  are  subject  to  value 
changes.  Assets  such  as  securities  often  fluctuate  in  market 
price.  The  desirability  of  recognizing  such  changes  in  the  ac- 
counts is  a  matter  of  some  dispute.  It  has  been  pointed  out 
several  times  in  the  preceding  pages  that  if  it  is  the  function  of 
the  accounts  to  present  as  nearly  as  possible  the  actual  situation 
all  value  changes  should  be  recorded.  In  so  far  as  the  ownership 
of  securities,  however,  arises  outside  of  the  regular  business  of 
an  enterprise,  variations  in  the  values  of  such  assets  can  hardly 
be  considered  as  affecting  either  gross  revenue  or  expense  totals. 
The  entries  given  under  cases  (2)  and  (4)  on  page  114  suggest  a 
more  proper  treatment  for  such  value  changes.  In  the  illus- 
trative case  of  the  A.  B.  Co.  it  will  be  assumed  that  the  balance 
of  the  Securities  Owned  account,  $4,000,  is  also  the  inventory 
figure.  This  account  would  then  be  closed  by  balancing  and  no 
closing  journal  entries  would  be  required. 

CLOSING   OTHER  CURRENT  ACCOUNTS 

In  addition  to  the  cases  already  discussed  there  are  many 
other  common  accounts  with  current  commodities  and  services 
that  involve  expense  (or  revenue)  items,  and  hence  furnish  prob- 


i78 


PRINCIPLES  OF  ACCOUNTING 


lems  of  interpretation  at  the  end  of  the  accounting  period.  In 
the  illustrative  trial  balance  of  the  A.  B.  Co.,  given  at  the  begin- 
ning of  this  chapter,  are  shown  Labor,  Fuel,  Insurance,  Mis- 
cellaneous Supplies  and  Services,  and  Rent  as  examples  of  such 
accounts.  These  accounts  will  be  briefly  discussed  in  the  order 
mentioned. 

Labor  shows  a  debit  balance  of  $8,540.  This  represents  the 
usual  situation ;  the  business  enterprise  buys  labor  services  but 
seldom  has  such  services  for  sale.  An  examination  of  the  payroll 
on  August  3ist,  it  will  be  assumed,  shows  that  not  only  have  all 
the  services  represented  by  this  debit  total  been  received  and 
consumed,  but  that  services  to  the  amount  of  $630  have  been 
consumed  for  which  payment  has  not  yet  been  made.  That  is, 
$8,540  plus  $630,  or  $9,170,  represents  the  total  value  of  labor 
power  which  has  been  utilized  during  the  past  accounting  period, 
or,  in  other  words,  the  total  labor  expense.  It  is  this  amount, 
and  not  the  cash  outlay,  which  should  be  charged  against  the 
revenue  of  the  past  month.  (The  amount  of  labor  cost  appli- 
cable to  goods  in  process  and  finished  goods  on  hand  is  assumed  to 
be  included  in  the  inventory  figures  for  these  assets ;  and  gross 
revenue  is  adjusted  to  allow  for  this  and  similar  items  as  explained 
in  a  preceding  section.)  The  closing  entries  would  be : 


Labor  Expense $9,170 


Labor 


$9,170 


If  no  special  Labor  Expense  account  were  used  the  entries  would 
be: 

Expense  and  Revenue $9,170 

Labor $9,170 

The  Labor  account,  closed,  would  now  appear  as  follows : 

LABOR 


1918 

1918 

Aug.  31 

C.B.5 

8,540 

Aug.  31 

J97 

9,170 

Inventory 

V 

630 

9,170 

Inventory 

9,170 

Sept.  i 

V 

630 

CLOSING  AND   INTERPRETING  ACCOUNTS 


179 


The  inventory  item  on  the  debit  side  of  this  account  repre- 
sents the  amount  which  must  be  added  to  the  trial  balance  figure 
to  give  the  total  labor  expense  for  the  period  as  explained  above. 
The  inventory  balance  in  this  case  represents  not  an  asset  but  an 
equity  item.  The  amount  of  $630  is  due  certain  laborers,  and 
the  Labor  account  is  used  for  convenience  to  show  their  equities. 
It  is  important  that  the  effect  of  this  accrued  liability  on  the  en- 
tries of  the  next  period  be  noted.  The  item  of  $630  will,  of  course, 
be  paid  shortly.  At  that  time  Cash  will  be  credited  and  Labor 
debited.  Entering  this  amount,  therefore,  as  an  equity  (a  credit) 
at  the  end  of  this  period  prevents  an  overstatement  of  the  labor 
services  consumed  in  the  succeeding  period  and  shows  as  well 
the  exact  status  of  the  enterprise  in  this  respect  at  the  present 
moment. 

The  Fuel  account  in  this  case  shows  a  debit  balance  of  $600. 
On  August  3ist,  it  will  be  assumed,  coal  in  the  bins  amounts  to 
$200.  The  closing  entries,  evidently,  would  be  as  follows : 


Fuel  Expense 
Fuel  . 


If  no  special  expense  account  were  opened  the  entries  would  be : 


Expense  and  Revenue 
Fuel  . 


$400 


The  Fuel  account,  closed,  would  now  appear  as  follows : 

FUEL 


1918 

I9l8 

Aug.  31 

C.B.s 

600 

Aug.  31 

J97 

400 

Inventory 

V 

200 

Inventory 

600 

600 

Sept.  i 

V 

2OO 

The  accounts  Insurance,  and  Miscellaneous  Supplies  and  Serv- 
ices, would  be  closed  in  a  similar  manner.  The  latter  account 
includes  such  items  as  postage,  stationery,  transportation  serv- 
ices, etc.  It  corresponds  to  the  more  familiar  "General  Ex- 
pense." Such  accounts  would  normally  show  asset  inventories. 


i8o 


PRINCIPLES  OF  ACCOUNTING 


In  this  case  it  will  be  assumed  that  insurance  prepaid  on  August 
3ist  amounts  to  $125,  and  that  stationery  and  other  supplies  on 
hand  are  valued  at  $100.  The  journal  entries  closing  these  ac- 
counts would  then  be  as  follows : 

(i) 

Expense  and  Revenue $125 

Insurance $125 

(2) 

Expense  and  Revenue $700 

Miscellaneous  Supplies  and  Services   .     .  $700 

The  accounts  would  be  balanced  and  the  inventories  brought 
down  as  in  the  case  of  the  Fuel  account  shown  above. 

The  Rent  account  in  this  case  shows  a  credit  total  of  $300. 
This  amount,  it  will  be  assumed,  represents  a  payment  to  the 
A.  B.  Co.  for  the  use  of  one  floor  of  its  building.  This  floor  is 
leased  by  the  S.  Co.  for  $1,200  per  year,  payable  quarterly  in 
advance.  On  August  ist  the  first  quarterly  payment  was  made. 
It  is  evident  that  at  the  end  of  the  month  the  A.  B.  Co.  can  con- 
sider but  one-third  of  this  sum  as  revenue  applicable  to  the  cur- 
rent period,  since  the  company  is  still  obligated  to  furnish  a  val- 
uable service  during  the  months  of  September  and  October.  In 
other  words,  $200  of  the  balance  now  appearing  in  the  Rent  ac- 
count represents  not  revenue  but  a  current  liability  —  a  liability 
which  will  be  retired  by  the  furnishing  of  a  continuous  service 
during  the  next  two  months  rather  than  by  a  lump  payment 
with  cash  or  an  equivalent.  The  journal  entries  necessary  to 
close  this  account  would  be  as  follows  : 


Rent 


$100 


Expense  and  Revenue $100 

The  Rent  account,  closed,  would  stand  as  follows : 

RENT 


1918 

1918 

Aug.  31 

J97 

IOO 

Aug.  31 

C.B.4 

300 

Inventory 

V 

200 

300 

Inventory 

300 

Sept.  i 

V 

200 

.     CLOSING  AND  INTERPRETING  ACCOUNTS  181 

In  many  cases  rent  is  paid  after  the  service  involved  is  furnished 
instead  of  being  prepaid,  as  in  the  above  illustration.  Both  asset 
and  liability  inventories  are  possible  in  connection  with  such  a 
case.  Accruals  of  rent  in  favor  of  the  lessor  represent  an  asset 
—  a  right  against  the  lessee  of  the  nature  of  an  account  receiv- 
able. Such  accruals  also  constitute  a  part  of  the  rent  revenue  for 
the  past  period,  although  this  portion  of  the  earnings  has  not  yet 
been  realized  in  cash.  On  the  books  of  the  lessee  rent  accruals 
represent  a  liability  —  a  claim  against  the  lessee  for  service  ren- 
dered of  the  nature  of  an  account  payable.  Further,  such  an 
accrual  should  be  considered  a  part  of  the  lessee's  operating  ex- 
penses for  the  past  period,  since  it  represents  the  value  of  a  serv- 
ice used  in  production  during  the  period  although  the  payment 
for  the  service  has  not  yet  been  made. 

In  addition  to  the  accounts  which  represent  the  purchase  and 
sale  of  current  commodities  and  services  accounts  with  current 
valuation  items  appear  in  nearly  every  trial  balance.  Examples 
of  current  valuation  items  are  cash  discounts  on  sales  and  pur- 
chases, rebates,  and  other  allowances.  Such  offsets  can  be  closed 
into  the  merchandise  accounts,  as  has  been  explained,  or  they 
may  be  carried  directly  to  Expense  and  Revenue.  In  the  trial 
balance  of  the  A.  B.  Co.  there  are  two  such  accounts,  Sales  Dis- 
counts and  Purchase  Discounts.  The  entries  closing  the  bal- 
ances of  these  accounts  into  Expense  and  Revenue  would  be  as 
follows : 

(i) 

Expense  and  Revenue $2,100 

Sales  Discounts $2,100 

0) 

Purchase  Discounts $1,900 

Expense  and  Revenue $1,900 

Although  the  total  amount  appearing  in  the  Sales  Discount 
account  is  evidently  a  proper  deduction  from  the  gross  revenue 
figure  for  the  current  period,  it  would  seem  to  be  not  quite  ac- 
curate to  consider  the  total  of  all  purchase  discounts  allowed 
during  August  as  offsets  to  current  costs  ;  for  a  considerable  part 
of  the  total  of  all  purchases  of  materials  made  during  the  month 
is  not  applicable  to  August  sales.  It  would  appear,  therefore, 


1 82  PRINCIPLES  OF  ACCOUNTING 

that  the  amount  of  purchase  discounts  applicable  to  goods  on 
hand  should  be  credited  to  Materials  rather  than  to  Expense  and 
Revenue.  If,  however,  the  inventories  of  materials,  goods  in 
process,  and  finished  goods  are  based  upon  net  prices  for  mate- 
rials and  supplies,  the  amount  which  is  transferred  from  Trading 
to  Expense  and  Revenue  will  involve  the  necessary  adjustment. 

SUMMARY   ACCOUNTS   FOR    SUNDRY  ASSETS  AND   LIABILITIES 

The  accounts  in  which  are  recorded  the  purchases  of  current 
commodities  and  services  such  as  fuel  and  insurance  can  with 
reason  be  considered  as  either  asset  or  expense  accounts  as  was 
explained  in  Chapter  III.  The  method  of  closing  shown  in  the 
preceding  section  is  consistent  with  the  view  that  such  accounts 
are  asset  accounts.  If  these  accounts  are  viewed  as  expense 
accounts,  however,  another  method  of  closing  would  seem  more 
logical.  This  alternative  procedure  (which  is  frequently  used 
in  practice)  will  be  briefly  explained. 

Since  an  expense  account  cannot  well  show  an  inventory  bal- 
ance, the  figure  in  any  case  which  represents  the  amount  of  a  cur- 
rent asset  which  has  not  expired  during  the  current  period  should 
be  transferred  at  the  end  of  the  period  to  a  special  asset  account. 
An  account  called  "  Sundry  Assets,"  or  by  a  similar  name,  may 
be  opened  for  this  purpose.  In  the  case  of  the  Fuel  account 
shown  in  the  last  section,  for  example,  the  inventory  figure  which 
represents  the  value  of  coal  on  hand  on  August  3ist  should  be 
closed  into  Sundry  Assets.  The  journal  entries  closing  the  Fuel 
account  if  this  procedure  were  adopted  would  be  as  follows  : 

(i) 

Sundry  Assets $200 

Fuel $200 

(2) 

Expense  and  Revenue $400 

Fuel $400 

The  entries  under  (i)  transfer  the  asset  balance  at  the  end  of  the 
month  from  Fuel,  an  expense  account,  to  Sundry  Assets.  The 
entries  under  (2)  shift  the  amount  of  fuel  expense  for  the  period 


CLOSING  AND   INTERPRETING  ACCOUNTS  183 

from  Fuel  to  Expense  and  Revenue.  The  Fuel  account  would 
now  show  no  balance. 

The  principal  advantage  to  be  derived  from  the  use  of  such  a 
special  asset  account  arises  in  connection  with  the  preparation 
of  the  balance  sheet.  Several  small  asset  items  may  in  this  way 
be  transferred  to  a  summary  account  and  appear  in  the  balance 
sheet  in  total,  rather  than  under  several  heads.  Thus  the  asset 
balances  of  the  Insurance  and  Miscellaneous  Supplies  and 
Services  accounts  mentioned  above  may  also  be  transferred  to 
Sundry  Assets.  The  importance  of  this  convenience,  however, 
may  be  easily  exaggerated.  It  is  quite  possible  to  collect  several 
account  balances  under  one  head  for  balance  sheet  purposes 
without  opening  a  special  ledger  account  and  closing  the  various 
balances  into  this  account.  In  other  words,  while  a  balance  sheet 
may  consist  simply  in  an  asset-equity  arrangement  of  the  ac- 
count balances  after  the  process  of  closing  is  completed,  any 
complete  statement  of  assets  and  equities  based  upon  these 
balances  —  however  the  items  be  combined  or  arranged  —  may 
be  said  to  constitute  a  balance  sheet  (see  Chapter  IX). 

When  a  Sundry  Assets  account  is  used  it  is  necessary  to  close 
this  account  and  reopen  the  various  expense  accounts  involved 
at  the  beginning  of  the  following  period.  On  September  ist, 
for  example,  it  would  be  necessary  to  reopen  the  A.  B.  Co.'s  Fuel 
account  by  the  following  entries : 

Fuel $200 

Sundry  Assets       $200 

These  entries,  evidently,  are  just  the  reverse  of  the  above  closing 
entries.  The  debit  to  Fuel  can  now  be  conceived  as  the  first 
purchase  of  coal  applicable  to  the  operation  of  the  business  dur- 
ing September. 

Similarly,  an  account,  Sundry  Liabilities,  may  be  opened  to 
serve  as  a  summary  account  for  the  various  small  liability  items 
which  are  discovered  to  be  accrued  at  the  end  of  an  accounting 
period.  In  the  case  of  the  Labor  account  discussed  in  the  pre- 
ceding section,  for  example,  the  following  entries  would  be  neces- 
sary to  close  the  account  if  this  procedure  were  adopted  : 

(i) 

Labor $630 

Sundry  Liabilities ,  $630 


1 84  PRINCIPLES  OF  ACCOUNTING 

(2) 

Expense  and  Revenue $9>i7o 

Labor $9,170 

On  September  ist  the  entries  under  (i)  would  be  reversed,  thus : 

Sundry  Liabilities $630 

Labor $630 

It  is  obvious  that  after  the  reopening  entries  are  made  in  any 
of  these  cases  the  account  involved  shows  exactly  the  same 
status  whether  closed  by  bringing  down  the  inventories  directly 
—  as  shown  in  the  last  section  —  or  by  making  use  of  special 
summary  accounts  for  the  inventory  items.  The  second  method 
is  somewhat  more  cumbersome  than  the  first,  in  that  it  involves 
the  use  of  an  additional  account  in  each  case  and  requires  addi- 
tional closing  and  opening  entries.  It  is  doubtful  whether  the 
advantages  of  this  procedure  outweigh  the  disadvantages. 


CLOSING   THE   EXPENSE   AND   REVENUE   ACCOUNTS 

As  has  been  indicated  several  times  in  the  preceding  pages  the 
special  expense  (and  revenue)  accounts  which  are  opened  for 
statistical  purposes  at  the  end  of  the  accounting  period  should 
finally  be  closed  into  a  summary  account,  Expense  and  Revenue. 
The  amounts  appearing  in  such  accounts  as  Depreciation  Ex- 
pense, Labor  Expense,  Fuel  Expense,  etc.,  as  well  as  in  such  in- 
termediate summary  accounts  as  Trading,  for  example,  are  trans- 
ferred to  this  summary  account.  The  journal  entries  necessary 
to  close  the  accounts  mentioned  (using  the  amounts  given  in  the 
preceding  illustrations)  would  be  as  follows : 

(0 

Expense  and  Revenue $350 

Depreciation  Expense $350 

(2) 

Expense  and  Revenue $9,170 

Labor  Expense $9,170 

(3) 

Expense  and  Revenue $400 

Fuel  Expense $400 


CLOSING  AND  INTERPRETING  ACCOUNTS  185 

(4) 

Trading $15,800 

Expense  and  Revenue       ....  $15,800 

In  the  trial  balance  of  the  A.  B.  Co.  shown  at  the  beginning  of 
this  chapter  there  were  evidently  no  pure  expense  or  revenue 
accounts ;  for  —  with  the  exception  of  the  valuation  accounts 
Purchase  Discounts  and  Sales  Discounts  —  an  inventory  has 
been  assumed  in  each  case  discussed.  It  would  be  quite  possible, 
however,  for  the  amount  of  a  commodity  or  service  consumed 
in  a  particular  case  to  coincide  with  the  amount  appearing  in 
the  trial  balance.  Freight  and  Cartage,  and  Repairs  to  Machin- 
ery are  typical  examples  of  expense  accounts  which  are  likely 
to  show  in  the  trial  balance  the  actual  deductions  from  revenue 
for  the  period.  All  such  accounts  are  also  closed  by  transfer- 
ring the  debit  balance  in  each  case  to  Expense  and  Revenue. 

If  it  be  assumed  that  in  addition  to  the  expenses  already  men- 
tioned in  the  preceding  pages  there  is  an  item  of  depreciation 
expense  in  connection  with  equipment  of  $300,  the  Expense  and 
Revenue  account  of  the  A.  B.  Co.,  when  closed  on  August  3ist, 
would  appear  as  follows  : 

EXPENSE  AND  REVENUE 


1918 

1918 

Aug.  31 

J96 

35° 

Aug.  31 

J96 

15,800 

J96 

300 

J97 

IOO 

J96 

330 

J97 

1,900 

J97 

9,170 

J97 

400 

J97 

125 

J97 

700 

J97 

2,100 

J98 

4,325 

17,800 

17,800 

The  balance  of  Expense  and  Revenue  is  the  net  revenue  (or 
net  deficit)  figure  —  the  difference  between  the  amount  of  all 
accruals  of  revenue  for  the  current  period  and  the  total  of  all 
commodities  and  services  which  have  expired  in  producing  this 


1 86  PRINCIPLES  OF  ACCOUNTING 

revenue.  In  the  above  case  revenues  exceed  expenses  by  $4,325. 
The  last  debit  entry  is  not  an  expense  charge  but  represents  rather 
the  withdrawal  of  the  net  revenue  element  from  the  summary 
account.  The  closing  journal  entries  would  be  as  follows  : 

Expense  and  Revenue $4,325 

Net  Revenue "...  $4,325 

In  accounting  practice  the  Expense  and  Revenue  account  is 
often  labeled  "Profit  and  Loss"  or  "Loss  and  Gain."  The 
particular  terminology  used  in  any  case  is  not  a  matter  of  great 
importance  provided  the  nature  of  the  account  is  clearly  under- 
stood. There  is  a  tendency  in  practice,  however,  to  combine 
both  gross  expense  and  revenue  items  and  net  revenue  charges 
and  credits  in  the  Profit  and  Loss  account.  This  practice  should 
be  avoided.  The  distinction  between  gross  revenue  and  net 
revenue  items  is  one  of  the  most  important  distinctions  in  ac- 
counting. To  confuse  the  Expense  and  Revenue  and  the  Net 
Revenue  accounts  destroys,  in  a  measure,  the  value  of  such 
accounts ;  and  any  such  procedure  is  likely  to  lead  to  improper 
classification  in  the  financial  statements. 

In  the  case  of  the  typical  large  scale  enterprise  where  an  at- 
tempt is  made  to  classify  expenses  not  only  in  terms  of  the  im- 
portant types  of  commodities  and  services  consumed  but  on  a 
functional  basis  as  well,  the  special  expense  accounts  set  up  may 
be  very  numerous,  and  the  task  of  opening  and  closing  such  a 
series  of  accounts  will  be  correspondingly  detailed.  A  number  of 
intermediate  summary  accounts  which  are  finally  closed  into 
Expense  and  Revenue  are  usually  employed.  Examples  of  such 
accounts  are  Buying  Expense,  Manufacturing  Expense,  Selling 
Expense,  and  General  Expense.  Similarly,  revenue  items  may 
be  classified  in  some  detail  in  the  accounts.  The  classifications 
given  on  pages  139-140,  and  on  page  142,  are  illustrative.  Care 
must  be  taken  in  such  cases  that  each  subsidiary  account  be  closed 
into  the  proper  intermediate  account.  Otherwise  the  conclusions 
drawn  by  the  management  from  the  data  furnished  by  these 
special  summary  accounts  will  be  misleading.  In  any  case, 
however,. the  process  of  closing  is  accomplished  in  an  analogous 
manner  to  the  procedure  outlined  above. 


CLOSING  AND   INTERPRETING  ACCOUNTS 


CLOSING   THE   NET  REVENUE   AND   EQUITY   ACCOUNTS 


I87 


The  last  step  in  closing  the  accounts  in  any  case  is  the  dis- 
tribution of  net  revenue  (or  the  allocation  of  net  deficit)  to  the 
various  equities  in  the  enterprise.  In  this  connection  the  rela- 
tion of  the  contractual  equities  to  the  enterprise  will  be  first  con- 
sidered. 

In  the  trial  balance  of  the  A.  B.  Co.  shown  on  page  152,  no 
Bond  Interest  account  appears.  This  is  due  to  the  fact  that 
there  has  been  no  actual  disbursement  to  the  bondholders  during 
the  month  of  August,  and  that  there  were  no  accruals  in  favor 
of  the  bondholders  on  August  ist.  (It  will  be  assumed,  for  con- 
venience, that  the  bonds  were  issued  on  August  ist.)  But  since 
the  bondholders  have  contractual  claims  upon  net  revenue  —  or 
upon  capital  if  there  is  no  net  revenue  —  their  equity  in  the 
enterprise  accrues  as  a  function  of  time,  and  consequently  the 
actual  increase  in  this  equity  during  an  accounting  period  seldom 
coincides  with  the  amount  paid.1 

In  this  case  it  will  be  assumed  that  the  outstanding  bonds  were 
issued  at  par,  and  that  the  interest  rate  is  six  per  cent,  payable 
semiannually.  The  accrued  interest  for  the  month  of  August, 
therefore,  amounts  to  $200.  It  is  this  amount  which  represents 
the  interest  of  the  bondholders  in  the  net  revenue  of  the  account- 
ing period  just  past.  The  entries  opening  the  Bond  Interest 
account,  and  appropriating  $200  from  Net  Revenue,  would  be 
as  follows : 

Net  Revenue $200 

Bond  Interest $200 

Bond  Interest,  closed,  would  now  appear  as  follows : 
BOND  INTEREST 


1918 
Aug.  31 

Inventory 

V 

200 

1918 
Aug.  31 

Inventory 

J98 

200 

200 

200 

Sept.  i 

V 

200 

1  Preferred  stockholders'  claims  may  also  be  said  to  accrue  in  time,  but  it  is  not 
customary  to  recognize  these  accruals  in  the  accounts.     Stockholders  as  well  as 


i88 


PRINCIPLES  OF  ACCOUNTING 


The  Commercial  Interest  account  in  the  illustrative  trial 
balance  shows  a  debit  total  of  $70  and  a  credit  total  of  $30. 
This  account  is  used  to  show  the  payments  made  to  the  equities 
represented  by  notes  payable,  and  items  of  net  revenue  received 
by  the  company  from  bank  balances  and  from  promissory  notes 
held  against  other  parties.  The  interpretation  of  this  account 
presents  some  difficulty.  The  debit  total  represents  payments 
actually  made  during  the  period  plus  interest  due  the  firm  at 
the  beginning  of  the  period  if  there  were  any  such  accrual.  The 
credit  total  shows  the  amounts  received  by  the  company  during 
the  period  for  rendering  the  service  of  capital  plus  any  interest 
accrued  and  unpaid  at  the  beginning  of  the  period.  It  will  be 
assumed  that  an  examination  of  the  company's  notes  receivable 
and  payable  at  this  date  shows  that  interest  is  accrued  on  notes 
receivable  to  the  amount  of  $20,  and  on  notes  payable,  $50. 
The  Commercial  Interest  account,  closed,  would  now  appear  as 
follows : 

COMMERCIAL  INTEREST 


1918 

1918 

Aug.  i 

Inventory 

V 

15 

Aug.  i 

Inventory 

V 

10 

3i 

C.B.5 

55 

3i 

C.B.4 

20 

Inventory 

V 

5o 

Inventory 

V 

2O 

J98 

70 

1  20 

1  2O 

Sept.  i 

Inventory 

V 

20 

Sept.  i 

Inventory 

V 

50 

The  closing  entries,  evidently,  would  be : 

Net  Revenue $70 

Commercial  Interest $70 

It  is  important  that  the  various  elements  represented  in  such 
a  complex  account  be  carefully  distinguished,  (i)  All  interest 
payments  made  during  the  period  are  entered  on  the  debit  side. 
These  items  represent  distributions  of  net  revenue  to  certain 
contractual  equities,  in  this  case  represented  by  notes  payable. 
(2)  All  payments  received  by  the  firm  for  furnishing  capital  to 
outsiders  are  entered  as  credits.  These  credits  are  additions  to 

bondholders,  however,  have  rights  of  legal  procedure  against  the  enterprise  if  their 
legitimate  claims  to  a  portion  of  net  revenue  are  not  being  recognized. 


CLOSING  AND  INTERPRETING  ACCOUNTS  189 

net  revenue,  for  they  represent  the  sale  of  the  services  of  the 
owners  where  no  deductions  are  involved.  (3)  The  interest  in- 
ventory which  shows  the  amount  of  interest  accrued  payable 
is  entered  as  a  credit.  This  element  of  the  account  then  repre- 
sents a  simple  equity  or  liability.  (4)  Interest  accrued  receivable 
is  recorded  as  a  debit  inventory.  (Each  inventory  is  first  en- 
tered on  the  opposite  side  for  the  purpose  of  making  the  closing 
computation.)  This  item  represents  an  asset,  a  right  against 
outside  parties.1  The  balance  of  this  complex  account  represents 
the  net  debit  or  credit  to  Net  Revenue.  (It  is  common  practice 
to  charge  such  a  balance  to  expense.  The  legitimacy  of  this  pro- 
cedure will  be  discussed  in  the  next  chapter.) 

It  would  be  possible  to  use  four  accounts  instead  of  one  to 
show  the  different  elements  in  the  above  case ;  and  wherever  the 
item  of  commercial  interest  is  large  it  is  no  doubt  best  to  adopt 
this  or  a  similar  procedure.  The  titles  of  such  accounts  could 
be :  (i)  Interest  Paid  ;  (2)  Interest  Received ;  (3)  Interest  Pay- 
able (equity) ;  (4)  Interest  Receivable  (asset). 

It  is  evident  that  some  enterprises  could  make  use  of  a  large 
number  of  interest  accounts,  not  only  to  record  the  various 
phases  of  interest,  but  to  show  the  relations  of  the  different 
classes  of  contractual  equities  to  the  company  as  a  whole. 

Distributions  to  the  proprietary  equities,  such  as  dividends 
on  capital  stock,  are  analogous  to  interest  payments  in  their 
effect  upon  net  revenue  and  the  fundamental  classes  in  the  ac- 
counting equation.  But  usually  these  distributions  are  residual 
and  not  contractual  in  character.  It  will  be  assumed  in  the  case 
of  the  A.  B.  Co.  that  the  directors  decide  to  post  a  dividend  of 
one  and  one-half  per  cent  on  August  3ist,  the  entire  amount  to 
be  appropriated  from  net  revenue.  The  entries  covering  this 
dividend  declaration  would  be : 

Net  Revenue $2,550 

Dividends $2,550 

When  these  dividends  are  finally  paid  the  journal  entries  would 
be  as  follows : 

1  Discount  arising  when  notes  payable  are  discounted  (sometimes  called  prepaid 
interest)  should  be  carefully  distinguished  from  an  asset  interest  inventory  if  one 
does  not  wish  to  obscure  the  net  revenue  figure. 


190  PRINCIPLES  OF  ACCOUNTING 

Dividends $2,550 

Cash $2,550 

These  entries,  evidently,  would  balance  the  Dividends  account. 
In  a  later  chapter  the  treatment  of  dividend  transactions  will 
receive  further  consideration. 

Transactions  involving  tax  payments  or  accruals  also  affect 
the  Net  Revenue  account,  as  already  explained.  Taxes  are 
usually  paid  annually  or  semiannually ;  but  if  these  items  can 
be  ascertained  beforehand  with  a  reasonable  degree  of  certainty 
accruals  should  be  taken  into  consideration.  It  will  be  assumed 
in  the  case  of  the  A.  B.  Co.  that  the  management  decides  to  ap- 
propriate from  the  net  revenue  for  August  the  amount  of  $250 
as  a  reserve  to  represent  the  accrual  of  state  and  federal  taxes. 
The  payments  made  at  the  end  of  the  fiscal  year  may  not  be 
exactly  on  this  basis,  since  the  company's  relation  to  the  govern- 
ment is  not  contractual.  This  estimate,  however,  it  will  be  as- 
sumed, is  based  upon  all  the  information  available.  The  entries 
recognizing  this  accrual  would  be : 

Net  Revenue $250 

Reserve  for  Taxes $250 

At  this  moment,  then,  the  equity  of  the  government  is  recog- 
nized on  the  books  to  the  extent  of  $250. 

As  was  emphasized  in  a  preceding  chapter,  any  actual  loss  that 
constitutes  a  net  decrease  in  equities  is  a  net  revenue  or  surplus 
item,  and  not  an  expense.  As  long  as  such  items  are  small  this 
analysis  is  not  of  very  great  importance,  but  a  significant  loss, 
if  treated  as  an  expense,  obscures  the  net  revenue  figure  and  in 
part  destroys  the  value  of  the  expense  and  revenue  accounts  for 
managerial  purposes.  Hence  all  actual  losses  should  be  debited 
to  the  Net  Revenue  or  Surplus  accounts  rather  than  to  Ex- 
pense and  Revenue.  In  this  case  it  will  be  assumed  that  there 
have  been  no  unusual  occurrences  giving  rise  to  actual 
loss. 

The  Net  Revenue  account  of  the  A.  B.  Co.  on  the  basis  of  the 
entries  that  have  been  discussed  would  now  appear  as  follows : 


CLOSING  AND  INTERPRETING  ACCOUNTS 

NET  REVENUE  l 


191 


1918 

1918 

Aug.  31 

J98 

70 

Aug.  31 

J98 

4,325 

J98 

200 

J98 

2,55° 

J98 

250 

J98 

1,255 

4,325 

4,325 

The  last  debit  entry  appearing  in  the  above  account  represents 
the  balance  of  net  revenue  which  has  not  been  specifically  ap- 
propriated, and  hence  may  be  transferred  to  Surplus.  The 
entries  closing  Net  Revenue  and  opening  the  Surplus  account 
would  be: 

Net  Revenue $i,255 

Surplus $1,255 

A  considerable  increase  in  the  stockholders'  equity,  in  addition 
to  the  amounts  appropriated  as  dividends,  interest  and  taxes, 
represents  the  result  of  the  operation  for  the  period.  If  opera- 
tion had  resulted  in  a  net  deficit,  the  stockholders'  equity,  at 
least,  would  have  been  decreased. 

The  Surplus  account,  balanced,  would  now  appear  as  follows : 

SURPLUS 


1918 
Aug.  31 

Balance 

V 

1,255 

1918 
Aug.  31 

Balance 

J98 

i,25S 

1,255 

i,255 

V 

i,255 

The  equity  adjustments  are  all  made  in  this  case  through  the 
subsidiary  equity  accounts,  Net  Revenue,  and  Surplus.  The 
accounts  Capital  Stock,  Bonds,  Notes  Payable,  and  Accounts 
Payable  are  left  unchanged  as  they  appear  in  the  trial  balance 
shown  at  the  beginning  of  the  chapter. 

1  This  account  has  been  called  the  "  Profit  and  Loss  Allocation  "  account. 
See  Oilman,  Principles  of  Accounting,  p.  213. 


DC 

THE  PREPARATION  OF  STATEMENTS 

AFTER  the  accounts  of  an  enterprise  have  been  properly 
adjusted  by  means  of  closing  entries  the  balances  appearing 
in  the  general  ledger  reveal  again  the  exact  current  status  of 
the  enterprise  (assuming  the  inventories  to  be  correct) ;  and 
the  financial  history  of  the  concern  for  the  past  accounting 
period  can  be  determined  by  a  careful  examination  of  the  books 
of  account  and  original  entry.  In  other  words,  the  ledger 
balances  at  this  time  disclose  the  present  condition  of  all  asset 
and  equity  items,  and  the  process  whereby  this  condition  was 
immediately  attained  is  represented  —  in  summary  form  at 
least  —  by  the  trial  balance  figures  and  the  closing  adjust- 
ments. The  task  of  reading  this  information  directly  from  the 
accounts,  however,  is  somewhat  difficult,  and  hence  an  im- 
portant part  of  the  accountant's  work  consists  in  the  prepara- 
tion of  statements  or  exhibits  which  present  in  compact  well- 
arranged  form  the  items  necessary  to  an  intelligible  showing 
of  the  various  important  phases  of  the  business  process  and 
its  results.  This  sort  of  information  is  invaluable  for  the  pur- 
poses of  the  operating  management,  the  board  of  directors, 
the  owners,  and  prospective  creditors  or  investors.  These 
interests  wish  to  secure  the  accounting  data  of  the  enterprise 
involved  in  any  case  in  summary  and  readable  form  since  they 
have  not  the  time,  opportunity,  or  skill  to  glean  the  desired 
information  directly  from  the  accounts. 

The  three  important  financial  statements  are :  (i)  the  expense 
and  revenue  statement;  (2)  the  net  revenue  and  surplus  statement;1 

1  The  surplus  statement  is  sometimes  considered  to  be  a  distinct  exhibit.  See 
Chapter  XXV. 

192 


PREPARATION  OF  STATEMENTS  193 

and  (3)  the  balance  sheet.  These  statements  will  be  briefly  dis- 
cussed in  the  order  named.  Some  special-column  devices  for 
computing  and  presenting  these  statements  —  of  value  chiefly 
to  the  student  and  the  practicing  accountant  —  will  also  be 
considered.  In  this  chapter  attention  will  be  directed  prin- 
cipally to  the  more  general  characteristics  of  financial  state- 
ments and  their  relation  to  the  underlying  system  of  accounts 
in  any  case.  A  more  elaborate  discussion  of  accounting  state- 
ments will  be  given  in  Part  Five. 


THE   EXPENSE   AND  REVENUE   STATEMENT 

The  expense  and  revenue  statement  in  any  case  is  a  systematic 
presentation  of  all  expenses  and  all  revenues  applicable  to  a  given 
accounting  period.1  That  is,  such  an  exhibit  shows  all  items  of 
gross  income  which  have  accrued  during  the  period,  and  the 
amounts  which  represent  the  commodities  and  services  which 
have  expired  in  producing  this  revenue;  and  its  concluding 
figure  is  the  net  revenue  or  net  deficit.  It  is  this  statement 
which  presents  the  results  of  business  operation,  and  hence 
reflects,  in  a  measure,  the  efficiency  of  the  operating  officials. 
It  is  the  net  balance  of  this  statement  which  shows  whether 
the  events  of  the  past  period  have  resulted  in  a  favorable  or 
unfavorable  change  in  the  status  of  the  private  equities  involved. 

If  all  items  of  expense  and  revenue  are  carried  to  a  summary 
account  as  explained  in  the  preceding  chapter,  that  account 
itself  is  virtually  an  expense  and  revenue  statement,  except 
that  the  amounts  are  not  itemized.  In  simple  account  form, 
therefore,  the  expense  and  revenue  statement  is  an  itemized 
replica  of  the  Expense  and  Revenue  account,  showing  all  ex- 
penses in  one  column  and  all  revenue  items  in  another.  The 
A.  B.  Co.'s  expense  and  revenue  statement  for  August,  for 
example,  as  constructed  from  the  Expense  and  Revenue  account 
shown  on  page  185,  would  appear  as  follows : 

1  In  accounting  practice  this  statement,  combined  with  the  net  revenue  and  sur- 
plus statement,  is  variously  called  the  "income  sheet,"  the  "profit  and  loss  state- 
ment," the  "loss  and  gain  statement,"  etc. 
o 


1 94 


PRINCIPLES  OF  ACCOUNTING 

A.  B.  Co.,  AUGUST  31,  1918 
EXPENSE  AND  REVENUE  STATEMENT 


Depreciation  of  Buildings 

$     350 

Trading  Revenue    . 

.     $15,800 

Depreciation  of  Equipment 

3°o 

Rent  from  Building 

IOO 

Allow,  for  Doubtful  Accts. 

33° 

Purchase  Discounts 

1,900 

Labor  Expense    .... 

9,170 

Fuel  Consumed        .     .     . 

400 

Insurance  Expired        .     . 

125 

Misc.  Supplies  and  Services 

700 

Sales  Discounts        .     .     . 

2,100 

Net     Revenue     (to     Net 

Revenue  Statement) 

4,325 

$17,800 


The  manner  of  determining  the  various  amounts  shown  in 
this  statement  was  explained  in  Chapter  VIII.  The  net  revenue 
figure,  $4,325,  is  carried  to  the  net  revenue  statement  to  be 
distributed  and  appropriated  in  accordance  with  contractual 
agreements  and  at  the  discretion  of  the  board  of  directors. 

The  simple  exhibit  shown  above  would  not  be  considered 
a  satisfactory  expense  and  revenue  statement  for  most  pur- 
poses. In  the  first  place  the  account  form  is  rather  technical, 
and  the  layman  consequently  finds  it  somewhat  difficult  to 
interpret  a  statement  prepared  in  this  way.  The  ''report," 
or  narrative  form,  has  some  advantages  in  this  respect.  Further, 
the  above  statement  is  much  too  condensed  to  form  a  satis- 
factory operating  sheet.  The  computations  and  adjustments 
which  gave  rise  to  the  item  of  trading  revenue,  for  example, 
should  be  shown  in  some  detail.  The  following  exhibit  shows 
the  expense  and  revenue  statement  of  the  A.  B.  Co.  prepared 
in  the  report  form,  and  including  the  computation  of  the  trading 
revenue  figure  (see  page  195). 

In  this  statement  discounts  on  purchases  and  sales  are 
treated  as  deductions  from  the  cost  of  materials  and  total  sales, 
respectively.  This  accounts  for  the  fact  that  the  amount  of 
trading  income  is  $15,600  instead  of  $15,800  as  in  the  preceding 
exhibit.  Accountants  are  not  at  all  agreed  as  to  the  exact 
incidence  or  location  of  such  discounts  in  the  financial  state- 
ments. Large  rebates  and  allowances  such  as  "trade"  dis- 


PREPARATION   OF   STATEMENTS 


195 


counts,  are  generally  handled  as  shown  below.  Cash  discounts, 
however,  are  often  accorded  different  treatment.  But  in  agree- 
ment with  the  explanation  of  such  items  given  in  Chapter  IV 
the  discounts  in  the  above  case  are  placed  in  the  trading  section 
of  the  expense  and  revenue  statement. 

EXPENSE  AND  REVENUE  STATEMENT  —  A.  B.  Co. 

For  Month  ending  August  3ist,  1918 
Trading  — 
Total  Sales $76,400 


Deduct  —  Sales  Discounts     . 

Gross  Trading  Revenue 
Materials  on  hand  August  ist 
Purchases  during  August  .     . 


Manufacturing  and  Selling  Costs  — 
Depreciation  of  Buildings       .     . 
Depreciation  of  Equipment    .     . 
Allowance  for  Doubtful  Accounts 

Labor      

Fuel 

Insurance    

Miscellaneous 

Total        

Manufacturing  Net  Revenue 


Other  Income  — 
Rent  from  Building 
Total  Net  Revenue 


2,100 


Deduct  —  Inventory  of  Materials 

August  3ist  .  .  .  .  $40,000 
Inventory  of  Goods  in 

Process  August  3ist  .  8,000 
Inventory  of  Finished 

Goods  August  31  st  .  12,000 
Purchase  Discounts  .  .  1,900 

Cost  of  Goods  Sold 
Trading  Income 


$ao,ooo 

40,600 

$120,600 


61,900 


$   3So 
300 

33° 

9,170 

400 

125 
700 


58,700 
$15,600 


ii,375 

$4,225 


,325 


There  are  certain  inaccuracies  in  the  above  statement  —  not 
affecting  the  concluding  net  revenue  figure,  however  —  which 


196  PRINCIPLES  OF  ACCOUNTING 

should  be  noted.  The  total  of  manufacturing  and  selling  costs 
is  overstated  by  the  amount  of  such  costs  applicable  to  the 
inventories  of  goods  in  process  and  finished  goods  as  was  ex- 
plained in  the  preceding  chapter.  In  other  words  a  part  of 
the  stated  deductions  from  the  gross  cost-of-materials  figure 
constitutes  an  offset  to  overstated  manufacturing  and  selling 
expense  figures.  The  cost  of  materials  is  understated ;  and  the 
total  of  other  expense  is  overstated  by  the  same  amount.  If  an 
adequate  system  of  cost  accounts  is  in  use  in  any  case  the  state- 
ments may  be  prepared  in  such  a  way  as  to  avoid  such  mis- 
statements.  Further,  it  is  very  unlikely  that  the  amount  of 
the  discounts  accepted  on  purchases  during  August  is  applicable 
to  materials  actually  consumed  in  producing  the  finished  goods 
sold  during  the  month.  If,  however,  it  be  assumed  that  the 
inventories  of  materials,  goods  in  process,  and  finished  goods  are 
based  upon  net  figures  as  far  as  the  prices  of  materials  are  con- 
cerned, the  entire  amount  of  purchase  discounts  should  be  con- 
sidered as  a  deduction  from  costs  as  was  stated  in  Chapter  VIII. 
Since  the  A.  B.  Co.  is  assumed  to  be  a  manufacturing  enter- 
prise, there  is  some  question  as  to  the  propriety  of  treating  the 
cost  of  materials  as  a  trading  deduction  from  gross  revenue. 
The  cost  of  materials,  it  might  be  urged,  is  essentially  a  manu- 
facturing cost.  The  procedure  shown  above  can  be  justified 
only  on  the  ground  of  an  assumption  that  in  the  case  of  the 
A.  B.  Co.  the  element  of  manufacture  is  so  slight  that  the  com- 
pany is,  in  many  respects,  very  similar  to  a  trading  enterprise. 
The  figures  given  in  this  case  are  in  agreement  with  such  an 
assumption.  Of  the  total  expense  for  the  month  ($58,700  plus 
$11,375)  about  eighty  per  cent  is  the  cost  of  materials  (ignoring 
the  errors  already  referred  to).  But  it  must  be  admitted  that 
even  in  cases  where  the  cost  of  raw  materials  constitutes  a  very 
large  part  of  the  total  expense  the  process  of  manufacture  may 
very  decidedly  alter  the  nature  and  appearance  of  the  materials 
used.  In  such  cases,  evidently,  goods  purchased  and  goods 
sold  cannot  from  any  viewpoint  be  said  to  be  identical.  Hence 
such  an  enterprise  cannot  be  considered  a  trading  company. 
For  the  sake  of  simplicity,  however,  the  trading  section  in  the 
above  statement  is  presented  in  much  the  same  form  as  would 
be  suitable  for  a  regular  trading  enterprise. 


PREPARATION  OF  STATEMENTS  197 

The  particular  way  in  which  an  expense  and  revenue  state- 
ment should  be  arranged  depends  not  only  upon  the  type  of 
enterprise  involved  in  any  case  but  also  upon  the  use  that  is 
to  be  made  of  the  statement.  In  general  it  is  the  operating 
management  which  is  particularly  interested  in  this  exhibit. 
Other  interests  such  as  the  directors,  stockholders,  or  creditors 
may  be  concerned,  however,  and  the  form  of  the  statement  may 
well  be  varied  somewhat  to  suit  the  needs  of  each  class.  For 
general  purposes  variations  of  the  report  form  are  probably  the 
most  usable. 

In  the  case  of  a  complex  enterprise  it  is  desirable  to  classify 
the  items  in  the  expense  and  revenue  statement  on  departmental 
and  functional  bases  much  more  elaborately  than  was  done  in 
the  above  illustrative  case.  The  construction  and  analysis  of 
such  statements,  and  the  uses  to  which  a  succession  of  these 
exhibits  may  be  put,  will  be  fully  discussed  in  Chapter  XXV. 


THE   NET  REVENUE   AND   SURPLUS   STATEMENT 

This  statement  begins  with  the  amount  of  net  revenue  as 
shown  by  the  expense  and  revenue  statement,  and  shows  the 
disposition  of  this  amount  among  the  various  interests  that 
have  claim  to  it.  It  shows,  further,  the  adjustments  which 
must  be  made  in  the  proprietary  equity  because  of  variations 
in  asset  values  which  arise  outside  of  regular  operating  transac- 
tions. In  the  case  of  a  corporation  this  statement  presents  a 
record  of  the  authorizations  of  the  board  of  directors  in  regard 
to  net  revenue  and  surplus.  If  there  are  several  distinct  equities 
in  the  enterprise  in  any  case  it  is  desirable  that  the  net  revenue 
section  be  subdivided  into  as  many  parts  as  there  are  distinct 
classes  of  equities  in  order  that  the  rights  of  each  group  of  owners 
in  the  net  revenue  may  be  clearly  presented. 

In  its  simplest  form  this  statement  is  an  itemized  presentation 
of  the  Net  Revenue  and  Surplus  accounts.     In  the  case  of  the 
A.  B.  Co.  the  net  revenue  statement  for  the  month  of  August  — 
based  upon  the  closing  entries  and  accounts  discussed  in  the  last 
chapter  —  would  appear  as  follows : 


IQ8  PRINCIPLES  OF  ACCOUNTING 

NET  REVENUE  AND  SURPLUS  STATEMENT 
A.  B.  Co.,  AUGUST  31,  1918 


Commercial  Interest 
Bond  Interest        .     . 
Dividends  Posted 

.  :  $   70 
.  .      200 

2  ;co 

Net    Revenue    (from    Ex- 
pense and  Revenue  State- 
ment)            $4,325 

Taxes  Accrued      .     . 
Surplus  for  Month     . 

.     .           250 

$4,325 

S4A25 

Arranged  in  narrative  form  this  statement  might  be  presented 
as  follows : 

NET  REVENUE  AND  SURPLUS  STATEMENT  —  A.  B.  Co. 
For  Month  Ending  August  3ist,  1918 

Total  Operating  Net  Revenue  for  Month   (from  Expense 

and  Revenue  Statement) »-  .     .     .  $4,325 

Deduct  —  Taxes  Accrued  during  August 250 

Net  Income  Accruing  to  the  Private  Equities $4,075 

Contractual  Deductions  — 

Net  Commercial  Interest  Deductions $  70 

Bond  Interest  Accrued  during  August 200 

270 

Net  Proprietary  Income $3,805 

Deduct  —  Dividends  Declared 

Surplus  for  August 

There  is  some  question  as  to  the  propriety  of  considering 
such  items  as  commercial  interest  as  belonging  in  the  net  revenue 
section  rather  than  in  the  expense  and  revenue  statement.  As 
was  explained  in  Chapter  VII  accruals  of  income  in  favor  of 
individuals  or  interests  furnishing  capital  to  the  enterprise  in 
any  case  are  not  expense  items  according  to  strict  logic.  Ex- 
pense charges  measure  the  expiration  of  commodities  and  serv- 
ices purchased  by  the  management  and  consumed  in  producing 
the  revenue  of  a  given  period.  Various  equities  —  stockholders, 
bondholders,  noteholders,  etc.  —  furnish  the  capital  which  is 
used  in  making  these  purchases.  The  excess  of  revenues  over 
expenses  constitutes  the  return  to  these  interests.  This  amount 
is  distributed  to  the  equities  in  accordance  with  the  rights  and 


PREPARATION  OF  STATEMENTS  199 

privileges  which  each  class  enjoys.  From  this  standpoint  all 
interest  accruals  are  clearly  in  the  same  general  accounting 
category  as  are  dividends  and  other  proprietary  items.  In 
some  cases,  however,  it  would  seem  somewhat  unreasonable 
to  insist  that  this  logical  analysis  be  followed  in  the  statements. 
If,  for  example,  ninety-five  per  cent  of  the  capital  in  a  particular 
case  is  furnished  by  the  proprietors,  contractual  accruals  of  net 
revenue  will  be  comparatively  slight  in  amount ;  and  such  items 
can  be  included  in  the  expense  and  revenue  statement  without 
serious  error.  In  such  a  case  the  net  revenue  and  surplus  state- 
ment will  be  practically  a  proprietary  sheet.  Further,  if  the 
expense  and  revenue  statement  be  conceived  as  a  record  of  the 
stewardship  of  the  operating  officials  and  employees,  and  is 
used  to  fix  their  responsibilities,  then  interest  on  current  borrow- 
ings can  be  considered  an  expense  in  so  far  as  the  operating 
management  is  really  responsible  for  these  borrowings. 

Whenever  contractual  equities  are  significant  in  amount  and 
run  for  long  terms,  however,  the  interest  charges  involved  should 
be  treated  as  net  revenue  items.  If  such  charges  are  treated  as 
expenses,  the  concluding  figure  of  the  expense  and  revenue 
statement  will  depend  upon  the  particular  scheme  of  financing 
employed  as  well  as  upon  the  results  of  business  operation. 
This  is  entirely  unreasonable.  To  include  interest  on  bonds, 
notes,  mortgages,  etc.  —  together  with  gross  revenues  and 
expenses  —  under  the  general  caption  "profit  and  loss,"  as  is 
done  by  so  many  accountants,  is  a  practice  which  destroys  in 
a  large  measure  the  value  of  the  statements  for  managerial 
purposes.  A  simple  illustration  will  perhaps  serve  to  make 
clear  the  impropriety  of  such  a  procedure.  The  A.  Co.  has 
outstanding  among  other  equities,  bonds  to  the  amount  of 
$100,000.  Interest  charges  on  these  bonds  amount  to  $6,000 
per  annum.  In  1916  this  sum  is  included  with  the  operating 
expenses  in  the  so-called  profit  and  loss  statement.  It  happens 
that  the  bond  contract  contains  a  provision  which  permits 
bondholders  to  exchange  their  securities  for  preferred  stock 
under  certain  conditions.  During  1917  a  considerable  number 
of  bondholders  avail  themselves  of  this  privilege.  Interest 
charges  are  thereby  reduced  to  $3,500.  Operating  expenses 
and  revenues,  it  will  be  assumed,  are  exactly  the  same  as  in 


200  PRINCIPLES  OF  ACCOUNTING 

1916.    The  profit   and   loss   statement   for   1917,   however  — 
which  again  includes  interest  charges  with  operating  expenses 

-would  show  a  net  revenue  greater  than  the  1916  balance 
by  the  amount  of  the  decrease  in  interest  charges.  Could  these 
statements  as  they  stand  be  used  for  comparative  purposes  to 
determine  the  efficiency  of  the  operating  management  ? 

The  distinction  between  expense  items  and  net  revenue 
charges  is  of  particular  importance  in  connection  with  the 
preparation  of  the  statements,  for  it  is  often  on  the  basis  of 
these 'statements  that  the  operating  management  and  the  board 
of  directors  make  the  important  decisions  of  business  and  financial 
policy.  And  other  interests  such  as  the  individual  stockholder 
and  bondholder,  or  the  prospective  creditor  or  investor,  usually 
see  nothing  of  the  accounting  records  with  the  exception  of  the 
statements.  It  is  essential,  therefore,  that  the  important  state- 
ments be  prepared  in  such  a  way  as  to  best  serve  the  purposes 
of  these  various  interests.  The  net  revenue  figure  is  one  of  the 
most  significant  amounts  shown  by  the  accounts ;  and  account- 
ing practices  should  be  carefully  scrutinized  with  a  view  to 
preserving  the  integrity  of  this  figure.  If  returns  to  contractual 
equities  are  listed  among  the  expenses  the  results  of  operation 
as  such  are  obscured. 

Tax  accruals,  as  was  explained  in  the  last  chapter,  stand  in 
an  anomalous  position  in  the  accounting  structure.  The  state 
does  not  furnish  capital  to  the  enterprise  in  any  case,  and  hence 
tax  payments  do  not  represent  a  return  to  capital.  As  far  as  the 
logic  of  the  case  is  concerned  it  would  seem  to  be  equally  proper 
to  place  the  deduction  for  taxes  in  the  net  revenue  section  or  in 
the  expense  and  revenue  statement.  Indeed  the  only  entirely 
satisfactory  treatment  for  taxes  in  the  statements  is  to  recognize 
this  item  as  congruous  with  no  other  figure.  But  if  the  tax 
charge  is  not  segregated  it  would  seem  to  be  the  most  rational 
procedure  to  place  this  item  among  the  net  revenue  deductions 
as  was  done  in  the  above  case.  Tax  accruals  represent  a  charge 
for  which  the  manager  is  in  no  way  responsible,  and  which  in 
no  way  reflects  upon  the  efficiency  of  operation.  Hence  this 
item  should  not  be  listed  among  the  expenses.  The  present 
"  excess-profits  "  and  income  taxes  are  certainly  levies  upon  in- 
come, and  are  in  nowise  deductions  from  gross  revenue. 


PREPARATION  OF  STATEMENTS  201 

In  the  second  of  the  above  exhibits  the  items  are  arranged 
according  to  priority  of  lien.  This  order  is  probably  the  most 
satisfactory.  Although  the  net  revenue  and  surplus  statement 
is  rather  simple  in  this  case  it  is  evident  that  in  the  case  of  a 
large  corporation  having  outstanding  several  types  of  stocks, 
bonds,  and  other  securities  the  net  revenue  section  of  the  financial 
statements  would  be  an  exhibit  of  considerable  size  and  im- 
portance. In  the  case  of  a  simple  single-proprietorship  or 
partnership,  on  the  other  hand,  this  statement  may  shrink  to 
insignificant  dimensions  or  even  practically  disappear. 

In  the  illustrative  case  of  the  A.  B.  Co.  no  surplus  appropria- 
tions have  been  assumed.  In  practice,  however,  both  interest 
and  dividend  appropriations  are  often  made  from  surplus, 
rather  than  from  current  income;  and  in  some  cases  such  dis- 
tributions are  even  made  from  invested  capital.  Items  of  net 
loss  or  net  gain  may  also  be  treated  as  deductions  from  or  addi- 
tions to  surplus,  as  was  previously  explained ;  and  the  surplus 
balance  may  be  subdivided  into  a  number  of  special  accounts 
by  order  of  the  board  of  directors.  In  such  a  case  the  surplus 
statement  may  be  prepared  as  a  distinct  exhibit,  showing  accu- 
mulated as  well  as  current  surplus.  The  A.  B.  Co.,  however, 
has  no  accumulated  surplus,  and  there  are  no  appropriations 
and  adjustments.  Hence  the  surplus  section  in  this  case  is 
rather  a  simple  affair,  consisting  merely  in  the  surplus  figure 
for  August.  This  figure  represents  the  amount  of  net  proprietary 
income  which  for  the  time  being  is  retained  in  the  business  as 
investment.  In  later  chapters  surplus  adjustments  will  be 
further  discussed. 

THE  BALANCE   SHEET 

The  balance  sheet  is  the  most  important  financial  statement. 
This  is  true  not  only  because  the  balance  sheet  is  the  basis  of 
the  entire  accounting  structure,  but  also  because  of  the  practical 
uses  to  which  this  statement  may  be  put  by  the  various  interests 
involved  in  any  case.  A  balance  sheet,  if  properly  prepared, 
furnishes  invaluable  information  to  directors,  stockholders, 
bondholders,  managers,  prospective  creditors  and  other  in- 
terests concerned ;  for  if  the  inventories  and  appraisals  are 
correct  this  statement  gives  an  accurate  presentation  of  the 


202 


PRINCIPLES  OF  ACCOUNTING 


financial  status  of  the  business  at  the  end  of  the  accounting 
period. 

The  balance  sheet,  in  its  simplest  form,  may  be  called  a  "  bal- 
ance of  balances."  It  is  a  summary  of  the  general  ledger  after 
the  process  of  closing  the  accounts  is  completed.  It  is  only  at 
this  time  that  the  books  represent  the  actual  state  of  affairs. 
Many  of  the  expenses  are  accruing  continuously,  and  the  day 
after  closing  in  any  case  the  accounts  will  fail  to  represent  the 
actual  status  of  the  enterprise  to  some  extent.  The  longer  the 
interval  between  inventories  the  larger  and  more  numerous 
will  be  the  discrepancies. 

Arranged  in  the  simple  account  form  the  balance  sheet  of  the 
A.  B.  Co.  on  August  3ist  would  appear  somewhat  as  follows:' 

BALANCE  SHEET 
A.  B.  Co.,  AUGUST  31,  1918  . 


Real  Estate       .... 
Buildings      

$  40,000 
60,650 

Capital  Stock    .     .     . 
Bonds       

.    $170,000 
4.0,000 

Equipment    

2  3.  7OO 

Notes  Payable 

8,700 

Materials       

40,000 

Accounts  Payable 

•                177  ?O 

Goods  in  Process    . 

8,000 

Rent     

2OO 

Finished  Goods 

12,000 

Dividends     . 

2,  CCO 

Cash    

26,200 

Labor       

Accounts  Receivable 
Notes  Receivable  .     .     . 
Securities  Owned   .     .     . 
Fuel     

10,670 
2,900 

4,000 
200 

Bond  Interest    .     .     . 
Reserve  for  Taxes 
Commercial  Interest  . 
Surplus     

200 
250 
50 

ij255 

Insurance      

125 

Miscellaneous      Supplies 
and  Services       .     .     . 
Commercial  Interest 

IOO 
2O 

$237.565 

$237,565 

The  above  statement  shows  simply  the  balances  of  the  asset 
and  equity  accounts  of  the  general  ledger  by  account  titles. 
Although  it  should  be  recognized  that  the  balance  sheet  is 
always  based  upon  these  balances,  the  point  should  be  em- 
phasized that  there  is  no  reason  why  account  titles  should  be 
exactly  followed  in  the  statement.  Other  individuals  than 
bookkeepers  and  accountants  wish  to  read  the  balance  sheet; 
and  since  the  account  names  are  often  abbreviated  and  tech- 
nical, the  items  in  the  balance  sheet  may  well  be  labeled  with 


PREPARATION  OF  STATEMENTS  203 

longer  and  more  intelligible  titles.  "Wages  Payable,"  for 
example,  would  be  a  more  appropriate  balance  sheet  heading 
than  " Labor."  Further,  the  above  statement  shows  no  valua- 
tion accounts ;  and,  as  was  explained  in  the  preceding  chapter, 
it  is  convenient  to  record  some  asset  expirations  by  using  valua- 
tion accounts.  Still  further,  it  is  usually  desirable  to  arrange 
the  items  on  both  sides  of  the  balance  sheet  into  subsidiary 
groups.  Many  of  the  important  facts  which  a  balance  sheet 
should  show  can  be  ascertained  only  from  a  comparison  of  special 
groups  of  asset  and  equity  items.  The  balance  sheet  of  the 
A.  B.  Co.,  revised  in  accordance  with  these  suggestions,  and 
arranged  in  the  report  form,  would  appear  as  follows : 

BALANCE  SHEET  —  A.  B.  Co. 
August  3ist,  1918 

Assets 
Fixed : 

Real  Estate       $40,000 

Buildings $70,000 

Less  —  Allowance  for  Depreciation  of 

Buildings  350 

69,650 

Equipment $24,000 

Less  —  Allowance  for  Depreciation  of 

Equipment 300 

23,700 
Total  Fixed  Assets $133,35° 

Current  Working : 

Materials $40,000 

Goods  in  Process 8,000 

Finished  Goods 12,000 

Total  Working  Assets 60,000 

Current  Liquid : 

Cash $26,200 

Accounts  Receivable       $11,000 

Less  —  Allowance  for  Doubtful  Accounts        330 

10,670 

Notes  Receivable        2,900 

Securities  Owned 4,000 

Interest  Accrued 20 

Total  Liquid  Assets 43,79° 


204  PRINCIPLES  OF  ACCOUNTING 

Sundry  Current : 

Fuel $200 

Insurance  Prepaid 125 

Miscellaneous  Supplies  and  Services 100 

Total  Sundry  Assets 425 

Total $237,565 

Equities 
Capital : 

Stock        $170,000 

Bonds       40,000 

Total  Capital  Equities $210,000 

Current  Liabilities : 

Notes  Payable       $  8,700 

Accounts  Payable       13.73° 

Bond  Interest  Accrued 200 

Commercial  Interest  Accrued       50 

Taxes  Accrued       250 

Wages  Payable 630 

Dividends  Payable 2,550 

Total  Current  Liabilities 26,110 

Deferred  Credits : 
Rent  Prepaid  (September  and  October)     ....  200 

Surplus : 

August  Balance 1,255 

Total $237,565 

Some  of  the  headings  in  the  above  statement  require  brief 
explanation.  The  term  "working"  is  often  applied  to  those 
assets  such  as  raw  materials  which  are  made  up  into  finished 
product  and  are  in  this  way  finally  converted  into  other  assets 
such  as  cash  and  accounts  receivable.  There  is  some  question 
as  to  the  propriety  of  listing  finished  goods  under  this  head ; 
for  such  goods  represent  the  product  ready  for  sale.  The  pro- 
ductive process,  however,  is  not  actually  completed  in  any 
case  until  the  sale  has  been  made;  and  although  this  part  of 
the  process  may  cause  little  or  no  change  in  the  physical  nature 
of  the  goods  involved,  it  is  still  a  necessary  step  in  production 
and  requires  certain  definite  costs.  Liquid  assets  are  assets 
which  will  either  normally  be  converted  directly  into  cash  within 
a  comparatively  short  time  or  at  any  rate  may  readily  be  so 


PREPARATION  OF  STATEMENTS  205 

* 

converted.  The  securities  which  the  A.  B.  Co.  owns  are  in- 
cluded in  this  group  on  the  basis  of  the  assumption  that  they 
may  be  liquidated  with  ease.  Fuel,  unexpired  insurance, 
supplies  on  hand  and  services  prepaid  are  examples  of  assets 
which  normally  expire  from  use  in  business  operation  and  can- 
not be  easily  liquidated  in  any  other  way.  Among  the  equities 
the  amount  of  rent  paid  in  advance,  although  really  a  current 
liability,  is  set  up  under  a  special  head  because  of  its  peculiar 
nature.  This  item  will  never  be  paid  in  cash  but  will  be  gradu- 
ally retired  as  the  A.  B.  Co.  furnishes  the  use  of  a  part  of  its 
equipment  to  the  lessee. 

Although  it  is  somewhat  difficult  to  establish  lines  of  division 
among  asset  and  equity  items  which  can  be  consistently  followed 
in  all  cases,  nevertheless  the  arrangement  of  the  balance  sheet 
data  into  sub-groups  is  a  matter  of  very  considerable  importance. 
Comparisons  between  fixed  assets  and  capital  equities,  between 
liquid  assets  and  current  liabilities,  between  current  assets  and 
fixed  assets,  etc.,  are  highly  illuminating.  The  particular  pur- 
poses to  be  served  in  any  case  should,  of  course,  condition  the 
nature  of  the  balance  sheet.  The  uses  to  which  the  sub-groups 
in  a  balance  sheet  may  be  put  in  making  comparisons  will  be 
fully  discussed  in  Chapter  XXVI. 

For  certain  purposes  a  much  condensed  balance  sheet  may  be 
most  adequate.  The  balance  sheets  published  by  large  corpora- 
tions are  usually  highly  summarized.  Care  should  be  taken  in 
preparing  such  general  balance  sheets  that  incongruous  items  are 
not  grouped  in  such  a  way  as  to  make  misinterpretation  very 
likely.  Such  captions  as  "real  estate,  goodwill,  etc."  for  ex- 
ample, should  not  appear  in  any  balance  sheet.  Certain  com- 
binations, however,  are  legitimate.  The  following  is  the  balance 
sheet  of  the  A.  B.  Co.  in  condensed  form  : 

Assets 

Plant  and  Equipment $134,000 

Less  Allowance  for  Depreciation 650 

$133,350 
Materials  and  Other  Working  Assets     .     .     .     .    .  60,000 

Notes  and  Accounts  Receivable $13,900 

Less  Allowance  for  Doubtful  Accounts       .     .     .  330 

13,570 


2O6 


PRINCIPLES  OF  ACCOUNTING 


Securities 
Cash    .    .    . 
Sundry  Assets 


$  4,000 

26,200 

445 


Equities 
Capital  Stock $170,000 


Bonds 

Notes  and  Accounts  Payable 
Dividends  Payable  .     .     .     . 
Interest  and  Taxes  Accrued 
Sundry  Liabilities     .     .     .     . 
Surplus        


40,000 
22,430 

2,550 
500 
830 

i,255 
$237,565 


Many  other  schemes  of  arrangement  are  possible.  The 
equities,  for  example,  may  be  classified  in  the  balance  sheet  as 
proprietorship  and  liability  items.  When  the  account  form  is 
used,  moreover,  asset  valuation  items  are  often  listed  in  the 
right-hand  column  among  the  equities,  and  equity  valuation 
items  —  if  there  are  any  such  —  are  placed  in  the  asset  column. 
The  following  statement  represents  —  in  summary  form  —  the 
A.  B.  Co.'s  balance  sheet  prepared  in  accordance  with  these 
suggestions : 


ASSETS 

Plant  and  Equipment 
Working  Assets  .  . 
Notes  and  Accounts 

Receivable     .    .    . 
Securities      .    .     .     . 

Cash 

Sundry  Assets        .    . 


EQUITIES 

$134,000      Liabilities : 
60,000         Bonds   .     .     .     .     .     .      $40,000 

Notes  and  Accounts 
13,900  Payable       ....         22,430 

4,000          Sundry  Liabilities   .     .  1,330 

26,200      Proprietorship: 

445          Capital  Stock      .     .     .       170,000 

Surplus 1,255 

Dividends  Payable       .  2,550 

Valuation : 

Allowance  for   Depre- 
ciation        ....  650 
Allowance  for  Doubtful 
Accounts    ....             330 

$238,545  $238,545 


PREPARATION  OF   STATEMENTS  207 

The  item  of  dividends  payable  is  included  among  the  proprietary 
items  in  this  case  on  the  ground  that,  although  a  legal  liability, 
it  represents  a  part  of  the  present  stockholders'  equity. 

A  single  balance  sheet,  although  a  very  useful  statement  in 
that  it  shows  the  status  of  the  enterprise  in  compact  form, 
gives  slight  clue  to  the  business  process  which  has  brought 
about  this  condition.  But  from  a  series  of  successive  monthly 
or  annual  balance  sheets,  together  with  auxiliary  information 
in  regard  to  investment  and  distributions  of  net  revenue,  the 
accountant  can  reconstruct  the  important  elements  in  the 
financial  "history  of  the  enterprise  in  any  case.  Since  the  bal- 
ance sheet  is  the  "origin  and  terminus  of  every  account,"1  a 
series  of  such  statements,  properly  interpreted,  throws  con- 
siderable light  on  the  business  process.  In  Chapter  XX VII  the 
construction  and  analysis  of  comparative  balance  sheets  will  be 
discussed. 

THE   TEN-COLUMN   STATEMENT 

As  a  first  step  in  making  up  the  financial  statements  the 
ten-column  statement,  is  a  convenient  working  device.  The 
exhibit  on  pages  208  and  209  illustrates  such  a  sheet. 

The  ten-column  statement  begins  in  any  case  with  the  trial 
balance  —  a  summary  of  ledger  debits  and  credits.  In  the 
inventory  columns  appear  such  asset  and  equity  inventories 
as  are  at  variance  with  the  trial  balance  figures.  An  analysis 
and  combination  of  the  trial  balance  and  inventory  figures 
give  the  data  for  the  balance  sheet  and  other  special  columns. 
The  above  statement  is  based  upon  the  trial  balance  of  the  A.B. 
Co.  appearing  on  page  152,  and  the  inventories  and  adjustments 
already  discussed  in  connection  with  this  trial  balance.  It  will 
be  desirable  to  examine  the  construction  of  this  exhibit  in  some 
detail,  for  the  ten-column  statement  is  an  important  working 
device. 

The  first  account  shown  in  the  trial  balance  columns  is  Real 
Estate,  with  a  debit  balance  of  $40,000.  No  new  inventory  is 
given,  hence  it  may  be  assumed  that  the  value  of  this  type  of 
property  is  unchanged.  There  has  been  no  expiration  of  value ; 
hence  there  is  no  expense  charge  to  be  considered  in  connection 

1  Sprague,  Philosophy  of  Accounts,  p.  26. 


208 


PRINCIPLES  OF  ACCOUNTING 


Hi 

S2  W 


o 
i^> 

VO 

<> 


88 

t^-  OO 


s  s 


s 


si 


> 


s 


pq 


PREPARATION  OF  STATEMENTS 


209 


•tj 

i 


o 
U 

PQ 
•<    oo 


< 


u 


O    O    O    O 


888 

O\   ^"    w 

M~VCT 


OOOOOOOO 


8O    O    O    O 
10  o    »o  10 


8  8 


—   M 


& 


210  PRINCIPLES  OF  ACCOUNTING 

with  this  asset.  The  trial  balance  figure,  therefore,  since  it  is 
identical  \vith  the  present  value  of  the  real  estate,  is  carried 
directly  to  the  asset  column  of  the  balance  sheet.  In  the  case 
of  the  next  account,  Buildings,  a  new  inventory  is  given.  The 
present  value  of  this  asset  is  $69,650.  The  difference  between 
the  new  inventory  and  the  debit  balance  of  the  Buildings  ac- 
count represents  the  amount  of  depreciation  expense  for  the 
past  period  as  far  as  this  asset  is  concerned.  This  difference, 
$350,  is  accordingly  carried  to  the  expense  column.  The  new 
inventory  figure,  however,  is  not  carried  to  the  balance  sheet. 
A  valuation  account,  Allowance  for  Depreciation  of  Buildings, 
is  used  in  this  case.  The  balance  in  the  Buildings  account  is 
carried  to  the  asset  column,  and  the  expiration  is  indicated  by 
placing  the  valuation  item,  $350,  among  the  equities.  The  two 
accounts  taken  together  now  indicate  the  actual  present  value 
of  the  asset.  The  accounts  Equipment,  and  Allowance  for 
Depreciation  of  Equipment,  are  handled  in  the  same  way. 
Neither  of  these  valuation  accounts  appears  in  the  original  trial 
balance  because,  as  previously  explained,  the  company  involved 
has  been  operating  for  a  single  period.  In  preparing  a  ten- 
column  statement  at  the  end  of  the  next  accounting  period  any 
new  items  of  depreciation  would  be  added  to  the  balances  then 
appearing  in  the  valuation  accounts,  and  the  totals  thus  deter- 
mined would  be  carried  to  the  equity  column.  The  new  de- 
preciation charges  would  be  listed  in  the  expense  column. 

The  Materials  account  shows  a  debit  balance  of  $120,600. 
The  present  inventory  is  $40,000.  The  inventory  figure  is 
listed  among  the  assets ;  the  difference  between  these  amounts 
is  carried  to  the  expense  column.  As  has  already  been  explained, 
this  difference  does  not  represent  the  actual  cost  of  materials 
for  the  period.  As  a  matter  of  clerical  efficiency  in  working 
out  a  ten-column  statement,  however,  it  is  convenient  to  treat 
each  account  as  a  unit,  without  reference  to  any  other  heading. 
When  this  is  done  any  overstatement  of  expense  or  revenue 
under  one  head  is  offset  by  an  equal  understatement  in  some 
other  connection,  and  vice  versa.  In  this  case  the  inventories  in 
connection  with  Goods  in  Process  and  Finished  Goods  are  used 
to  adjust  overstated  costs  as  was  previously  explained.  These 
accounts  show  no  trial  balance  figures.  The  inventory  items, 


PREPARATION  OF   STATEMENTS  211 

therefore,  are  carried  to  the  balance  sheet  as  they  stand.  These 
same  amounts  must  also  be  listed  in  the  revenue  column  as  cost 
adjustments. 

Since  no  new  cash  inventory  is  given  it  may  be  assumed  that 
the  net  debit  balance  as  shown  by  the  trial  balance  represents 
the  cash  actually  on  hand.  Hence  there  is  neither  expense  nor 
revenue  in  connection  with  this  property  item.  The  debit 
balance,  $26,200,  is  carried  to  the  asset  column.  If  cash  had 
been  lost  or  stolen  the  inventory  would  not  have  coincided  with 
the  balance  of  the  Cash  account,  and  an  "  extraordinary "  ex- 
pense would  have  arisen.  Notes  Receivable  and  Securities 
Owned  are  also  accounts  which  show  in  the  trial  balance  the 
exact  present  status  of  the  assets  involved.  The  balances  of 
these  accounts,  accordingly,  are  listed  in  the  asset  column. 
There  is  an  inventory  in  connection  with  Accounts  Receivable, 
however,  which  is  $330  less  than  the  net  balance  of  the  account. 
This  difference  is  listed  in  the  expense  column  as  a  charge  against 
revenue.  The  actual  balance  is  carried  to  the  asset  column ; 
and  the  amount  of  the  expiration  is  listed  among  the  equities 
under  the  head,  Allowance  for  Uncollectible  Accounts.  As  was 
explained  in  another  connection  it  is  essential  that  a  valuation 
account  be  used  in  such  a  case. 

The  Labor  account  shows  a  liability  inventory.  The  debit 
total  in  this  account  indicates  the  total  amount  of  labor  services 
purchased  and  paid  for  during  the  period.  As  was  explained 
in  Chapter  VIII,  the  credit  or  liability  inventory  shows  that 
this  entire  amount  of  labor  services  has  been  consumed  during 
the  period  and  that  in  addition  services  have  been  used  to  the 
amount  of  $630  for  which  payment  has  not  yet  been  made. 
Then  the  total  amount  of  labor  expense  is  the  debit  total  of 
the  Labor  account  plus  the  inventory  representing  wages  un- 
paid, or  $9,170.  This  amount  is  carried  to  the  expense  column. 
The  inventory  figure,  $630,  represents  a  current  right  against 
the  assets  of  the  company  and  is  accordingly  listed  among  the 
equities.  Fuel,  Insurance,  and  Miscellaneous  Supplies  and 
Services  show  asset  inventories  in  each  case.  The  inventory 
figures  are  carried  to  the  asset  column.  The  difference  between 
the  inventory  and  the  trial  balance  amount  in  each  case  is  ex- 
pense, and  this  difference  is  listed  among  the  expenses.  If  no 


212  PRINCIPLES  OF  ACCOUNTING 

inventories  had  been  given  in  connection  with  these  three  ac- 
counts the  reasonable  assumption  would  be  that  the  net  trial 
balance  figure  in  each  case  constituted  an  expense  rather  than 
an  asset  figure.  This  follows  from  the  nature  of  the  commodities 
and  services  involved. 

Purchase  and  sales  discounts  are  offsets  to  goods  purchased 
and  sold  as  was  previously  explained.  They  are  current  valua- 
tion items  and  should  be  carried  to  the  expense  and  revenue 
columns  to  adjust  overstated  costs  and  revenues.  Since  such 
items  are  neither  asset  nor  equity  balances  they  do  not  appear 
in  the  balance  sheet. 

The  Rent  account  shows  a  credit  balance  of  $300.  If  there 
were  no  inventory  item  given  it  would  mean  that  this  entire 
amount  were  revenue,  and  should  be  carried  to  the  revenue 
column.  In  this  case  there  is  a  liability  inventory  of  $200. 
The  amount  of  revenue  for  this  period,  therefore,  is  but  $100. 
The  inventory  figure  is  listed  among  the  equities.  The  different 
types  of  inventories  possible  in  connection  with  the  Rent  ac- 
count were  explained  in  the  preceding  chapter. 

Items  of  interest  should  be  considered  as  net  revenue  debits 
and  credits  as  was  explained  in  the  last  chapter.  The  net 
balance  of  Commercial  Interest,  then,  after  being  adjusted  by 
the  inventories,  is  carried  to  the  debit  column  of  the  net  revenue 
and  surplus  statement.  The  liability  inventory  is  listed  in  the 
equity  column  and  the  asset  inventory  is  carried  to  the  asset 
column.  The  beginner  is  inclined  to  wish  to  combine  these 
items  and  show  only  the  difference  in  the  balance  sheet.  This 
should  never  be  done.  These  columns  should  show  all  asset 
and  equity  items,  and  hence  no  cancellation  is  proper.  Ob- 
viously one  entire  column  of  the  balance  sheet  might  be  cancelled 
against  the  other,  since  the  totals  are  the  same,  and  this  pro- 
cedure would  destroy  the  statement.  Any  algebraic  summation 
of  asset  and  liability  items  is  simply  a  step  in  this  direction. 

The  Bond  Interest  account  does  not  appear  in  the  trial  balance. 
There  is  an  inventory  item  in  connection  with  this  account, 
however,  representing  bond  interest  accrued  but  unpaid.  This 
item  is  clearly  an  equity  balance  and  is  carried  to  the  balance 
sheet.  It  is  also  an  accrued  deduction  from  net  revenue,  and 
hence  is  listed  in  the  debit  column  of  the  net  revenue  and  surplus 


PREPARATION  OF  STATEMENTS  213 

statement.  Similarly  no  figures  appear  in  the  trial  balance 
for  dividends  and  taxes.  Among  the  inventories,  however,  are 
listed  a  dividend  appropriation  of  $2,550  and  a  tax  accrual  of 
$250.  The  dividend  inventory  is  an  equity  item  and  is  ac- 
cordingly carried  to  the  balance  sheet.  It  is  also  a  distribution 
of  net  revenue.  The  tax  accrual  is  a  government  claim  and  is 
also  listed  among  the  equities.  It  is  carried  to  the  net  revenue 
columns  because  it  constitutes  a  deduction  from  net  revenue  as 
was  explained  in  the  preceding  chapter. 

Capital  Stock,  Bonds,  Notes  Payable,  and  Accounts  Payable 
are  typical  equity  accounts.  No  inventories  or  adjustments 
have  been  assumed  in  connection  with  these  accounts ;  and 
hence  the  net  balances  as  shown  by  the  trial  balance  statement 
are  carried  directly  to  the  equity  side  of  the  balance  sheet. 

Starting  with  a  trial  balance  that  "proves"  the  numerical 
computation  involved  in  a  ten-column  statement  is  shown  to 
be  correct  if  the  final  balance  of  the  net  revenue  and  surplus 
columns  added  to  the  equity  side  of  the  balance  Sheet  (the  asset 
side  in  the  case  of  a  net  deficit)  equates  resources  and  equities. 
The  asset  column  shows  the  present  status  of  all  assets ;  but 
the  equity  column  does  not  include  the  unappropriated  net 
revenue  balance.  The  total  of  the  equities  to  date  is  not  dis- 
covered until  the  balance  of  the  net  revenue  and  surplus  columns 
is  incorporated  with  the  surplus  from  the  preceding  period. 
When  this  is  done  assets  again  equal  equities.  In  the  illus- 
trative case  of  the  A.  B.  Co.  there  is  no  accumulated  surplus. 
Hence  the  surplus  for  August,  $1,255,  is  also  the  balance  of  the 
Surplus  account. 

To  aid  the  student  in  working  out  such  statements  as  the  one 
just  discussed  a  few  general  suggestions  may  be  given  at  this 
point.  It  is  evident  that  whenever  a  debit  or  asset  inventory 
is  given  in  connection  with  an  asset  account,  the  inventory 
figure  is  carried  as  an  asset  to  the  balance  sheet  (assuming 
that  there  is  no  valuation  account),  and  the  difference  between 
the  inventory  item  and  the  net  amount  shown  by  the  trial 
balance  constitutes  the  expense  item  that  is  carried  to  the  ex- 
pense column.  If  a  valuation  account  is  used  the  book  value 
of  the  asset  (the  amount  appearing  in  the  main  asset  account) 
is  listed  in  the  asset  column.  The  amount  of  the  expiration  is 


214  PRINCIPLES  OF  ACCOUNTING 

added  to  any  credit  balance  already  found  in  the  valuation 
account,  and  the  sum  so  determined  is  carried  to  the  credit 
column  of  the  balance  sheet.  Where  a  valuation  account  such 
as  Allowance  for  Depreciation  is  found  in  the  trial  balance  care 
must  be  taken  that  the  net  book  value  of  the  asset  —  i.e.,  the 
difference  between  the  amount  appearing  in  the  main  asset 
account  and  the  balance  already  shown  in  the  valuation  account 
-  be  compared  with  the  new  inventory  in  determining  the 
amount  of  expense.  If  the  amount  of  the  new  inventory  is 
greater  in  any  case  than  the  net  book  value  appearing  in  the 
trial  balance  this  means  that  appreciation  has  occurred.  The 
amount  of  the  increase  in  such  a  case  should  be  carried  to  the 
revenue  column  if  it  can  be  considered  as  applicable  to  the 
current  period.  If  this  is  an  unusual  happening,  or  covers 
several  accounting  periods,  the  item  of  appreciation  should  be 
listed  in  the  credit  net  revenue  or  surplus  column.  The  in- 
creased inventory  may  be  listed  as  an  asset,  or  the  amount  of 
the  increase  may  be  deducted  from  the  balance  appearing  in 
the  appropriate  valuation  account  if  there  is  such  an  account. 

Whenever  there  is  a  liability  or  credit  inventory  in  connection 
with  a  current  asset  or  expense  account,  there  is  no  asset  to 
carry  to  the  balance  sheet.  The  liability  inventory  figure  is 
listed  among  the  equities,  and  the  sum  of  the  inventory  and  the 
balance  of  the  account  as  shown  by  the  trial  balance  is  carried 
to  the  expense  column.  Inventories  in  connection  with  net 
revenue  accounts  are  handled  in  the  same  way  except  that  the 
adjusted  figure  is  carried  to  the  appropriate  net  revenue  column. 
Whenever  an  asset  inventory  is  given,  such  as  the  goods  in 
process  inventory  in  the  above  case,  and  there  are  no  corre- 
sponding trial  balance  figures,  the  amount  of  the  inventory  is 
listed  among  the  assets  and  is  also  placed  in  the  revenue  column 
to  offset  overstated  expense  charges.  If  such  an  inventory 
represented  a  gift  or  donation  the  corresponding  credit  would 
be  carried  to  the  net  revenue  columns. 

It  should  be  borne  in  mind  that  there  is  nothing  arbitrary 
about  such  a  device  as  the  ten-column  statement.  It  involves 
simply  a  particular  method  of  distributing  debit  and  credit 
items.  The  trial  balance  shows  an  equality  of  debit  and  credit 
totals.  These  debit  and  credit  balances,  adjusted  by  means 


PREPARATION  OF   STATEMENTS  215 

of  inventories,  are  distributed  as  assets  and  equities,  as  expense 
and  revenue  charges  and  credits,  and  as  net  revenue  and  surplus 
items.  Each  inventory  adjustment  affects  the  sum  totals  of 
debits  and  credits  alike.  The  underlying  equation  is  thus  at 
all  times  maintained;  and  by  striking  a  final  balance,  as  ex- 
plained above,  the  accuracy  of  the  work  is  proved.  From  a 
completed  ten-column  statement  the  regular  balance  sheets  and 
other  statements  previously  described  may  be  readily  prepared. 

THE    WORKING   SHEET 

Although  the  ten-column  statement  is  a  convenient  clerical 
device  it  is  not  in  common  use.  Accountants  quite  generally 
employ  another  form  of  "working  sheet"  which  includes  more 
or  less  of  the  closing  entries  and  an  "adjusted"  trial  balance. 
Because  of  its  wide  use  the  student  should  be  familiar  with  the 
general  characteristics  of  this  form.  An  illustration  will  serve 
to  explain  the  nature  of  the  working  sheet  and  the  way  it  is 
constructed  from  an  underlying  trial  balance  and  accompanying 
inventories. 

The  following  is  the  trial  balance  of  C.  A.  Black,  Proprietor, 
as  of  December  3ist,  1917  : 

ACCOUNTS  Dr.              Cr. 

Accounts  Payable       $  $  10,600 

Accounts  Receivable       29,000 

Cash 8,200 

C.  A.  Black,  Capital       22,500 

Interest  Received       500 

Interest  Paid 800 

Merchandise  Inventory 20,000 

.Miscellaneous  Expense i>3oo 

Notes  Payable       12,000 

Office  Equipment       800 

Other  Selling  Expense f  3,500 

Office  Salaries 4,7°o 

Purchases 87,000 

Purchase  Returns       .'"  i,3°o 

Rent 600 

Store  Equipment 3,ooo 

Sales 128,000 

Sales  Returns 2,500 

Salesmen's  Salaries 12,000 

Sales  Discounts 1,500 

$174,000        $174,900 


216 


PRINCIPLES  OF  ACCOUNTING 


EXPENSE  AND 
REVENUE 

d 

°                               88 

to                                                         PO                 O 

00 
M 

o 

O          Q                QOQ          O                QOQ 
M           O                 O    *o  o         vO                 O    PI    O 
O\         ro                *o  oO    O          *o               10  ro  *o 

M                 co  ^t"  r^                            PI    PI    M 

00                                                    IH 

BALANCE  SHEET 

.8 

I 

88               8 

\5            10                     o 
o"            pT                     pT 

M                           PI                                               M 

! 

O    Q                    Q              Q                              Q 
n    o                    Q              O                              Q 

o\  oo                   <"O                                           PO 

<N                                           P> 

ADJUSTED  TRIAL 
BALANCE 

u 

O               Q    O                     Q                          Q               Q 
\o               vo  10                    O                           co              O 

o"             pT                       PI"                       M"            oo" 

M                           PI                                               M                                                                              M 
M 

L4 

O 

§O                OQQ          QQOQ          OQ          QOQ 
O                MOO          OO*oo         ^x          OP<O 

C>  oo"                        cow                  co^t^                 co          PIPIW 
MM                                              00                                                w 

ADJUSTING  ENTRIES 

U 

O                                                              O 

<*         3                          S 

O 

O    Q                              O                                          O 

w      Q                                       IJ~>                                                      P< 

TRIAL  BALANCE 

U 

JO    Q                       O                              O                 Q                         Q 
O    O                       Q                              O                 Q                         O 
10  10                      o                              co                O                         O^ 

o"            PI"                      pT                      i-T           oo"                  *f 

M                        «S                                           H                                                                       PI                                   t^- 

l-l                              w 

0 

§Q              QQQ         QQQQ         QO         QOQQ 
O                 OOO           OOOQ           OO           OOOO 
PI                 OO    O    ^O         OO    >o  |>.   O          ^    O           *o   O    *o     0s 

O\  OO                         O    t~<                  PO  ^i"   f^-                 PO          Pi     Pi    w      ^~ 

PI                                               PI                                                       OO                                                         M                  f- 
H 

Account  Titles 

1*8           o 

«     •—  i          2  ^          c 

||  !1  If  Jl    I  1  J| 

IJ^ililiiiiJiiiiili 

PREPARATION  OF   STATEMENTS 


217 


D. 
O 


< 
o 


LO 
O 


o 

oo^ 

p 

o 

CO 

CN 

<  w 

?r 

W  Z 

ft 

£ 

W  Ea 

O                                        0 

O    O      O 

OO                                         VO 

OO    ^o     co 

R  W 

co                                       cs 

O    t^.  oo 

H 

O 

M       M         CO 

^ 

<£                ^ 

g 

.s 

*J 

O                   O     O            O            O 

M                        OO      V>              <N              *O 
M                         CO    M                CO              <N 

O    O      O 
co  t^     O 

M 

'3 

H 

o- 

t/3 

M 

^t"     HH       ^O 

4^ 

t&            €# 

0                                        O 

' 

O 

3 

1 

o^ 

PQ 

I 

^ 

s 

O    Q           O    O           O           O 

M     O             OO     >O             CS             O 

o 

LO 

ri 

MO                 CO     M                 CO               C^ 

H 

1 

O 

CO 

<> 

H  o 

^ 

t^ 

!« 

O                   O                   O            O 

co                OO                  -^-         VO 
co                               ?* 

O 

U"> 

M 

i 

Q 

m 

C? 
M 

§ 
E 

d 

o   o        o   o        o        o 

M     Q          OO    **~>          ^          vO 
MO            co   M            co          M 

co 

O 

01 

w 

•"O    <o         "^i    ^          t*o       "^i 

^ 

o 

0                  0                  O           O 

O 

£* 

CO                 OO                    rj-          \O 

a> 

B 

co                               cs 

W 

I 

o 

T? 

^ 

3       S       S    S 

±& 

1 

u 

1 

Q 

-^                                                  V 

ctf     1>                                      "^ 

:ount  Tides 

ill    ill          1 

«  5  i  1  11  .§ 

< 

|!l|l||l  1 

1 

;-j-3§M&(u'^ 

£ 

u  b  a,  d,  o  ,H  g<^  «   « 

QJ 

<-<WQ<o£c/?HH 

s 

2i8  PRINCIPLES  OF  ACCOUNTING 

The  inventories  and  adjustments  are  as  follows  :  merchandise, 
$23,000;  taxes  accrued,  $260;  office  salaries  due  but  unpaid, 
$150;  salesmen's  salaries  unpaid,  $320;  interest  accrued  on 
bank  balance,  $30;  interest  accrued  on  notes  payable,  $110; 
rent  prepaid,  $40 ;  store  equipment,  $2,700 ;  office  equipment, 
$720. 

The  exhibits  on  pages  216  and  217  illustrate  a  working  sheet 
prepared  from  the  above  data. 

The  type  of  working  sheet  illustrated  above  may  con- 
veniently be  used  for  the  purpose  of  constructing  adjusting 
entries,  and  to  prove  the  clerical  accuracy  of  this  work.  The 
adjusted  trial  balance  shows  the  condition  of  the  ledger  after 
all  necessary  special  accounts  have  been  opened,  but  before 
the  various  expense  and  revenue  items  have  been  combined 
in  a  summary  account,  and  before  the  amount  of  net  income 
has  been  transferred  to  the  various  equity  accounts.  Such 
an  intermediate  trial  balance  is  of  advantage  as  a  test  for 
accuracy  in  any  case  in  which  the  closing  entries  are  very 
numerous  and  complex.  The  letters  used  in  the  columns  con- 
taining the  entries  serve  to  connect  the  corresponding  debit 
and  credit  items. 

An  advantage  which  this  form  of  working  sheet  has  over  the 
ten-column  statement  shown  in  the  preceding  section  lies  in  the 
fact  that  the  various  adjustment  headings  are  presented.  This 
procedure  makes  it  possible  to  interpret  the  statement  more 
easily  than  if  several  distinct  facts  were  listed  under  a  single 
head.  In  the  illustrative  ten-column  statement,  for  example, 
expense  and  liability  items  are  shown  in  a  single  line  with  the 
trial  balance  figure  of  the  Labor  account  and  its  inventory.  In 
the  more  common  form  of  working  sheet  the  liability  item  would 
be  set  up  under  a  distinct  head  such  as  "Accrued  Wages  Payable." 
The  simplicity  of  the  ten-column  statement,  however,  and  the 
fact  that  it  shows  the  inventories,  make  this  form  in  some  respects 
the  more  usable  device. 

In  the  above  working  sheet  no  distinction  is  made  between 
expense  and  revenue  and  net  revenue  items.  This  is  typical  of 
actual  practice.  Most  accountants  prepare  a  working  sheet 
as  a  proprietary  statement,  the  concluding  net  figure  being  the 
net  proprietary  income.  As  already  explained,  however,  to 


PREPARATION  OF   STATEMENTS  219 

include  interest  charges  —  a  return  to  capital  —  and  taxes  —  a 
net  revenue  deduction  rather  than  an  operating  deduction  - 
with  the  expense  charges,  is  a  practice  which  conforms  neither 
to  logical  relationships  nor  to  practical  considerations  in  many 
cases. 


X 

THE  DETERMINATION  OF  NET  REVENUE 

IN  the  discussion  of  the  closing  and  interpretation  of  accounts 
in  Chapter  VIII  the  general  problem  of  ascertaining  net  revenue 
was  raised.  It  was  shown  that  in  any  case  the  trial  balance  — 
a  summary  of  the  open  ledger  accounts  —  does  not  alone  fur- 
nish the  data  from  which  may  be  determined  either  the  present 
financial  status  of  the  business  or  the  expenses  and  revenues 
for  the  past  accounting  period.  It  is  necessary  to  take  inven- 
tories and  to  make  adjustments  in  order  to  ascertain  the  accruals 
of  cost  and  income  and  the  current  condition  of  all  properties 
and  property  rights.  In  other  words,  the  data  of  the  business 
process  must  be  carefully  analyzed  at  the  end  of  each  period  so 
that  each  item  may  be  allocated  to  its  proper  place  in  the  ac- 
counts and  statements.  In  this  connection  many  difficult 
problems  of  interpretation  and  classification  arise.  In  this 
chapter  some  of  the  more  important  of  these  topics  will  be 
discussed  —  particularly  as  regards  the  relation  of  each  question 
to  the  integrity  of  the  net  revenue  figure. 

THE   SIGNIFICANCE   OF   NET  REVENUE 

In  an  important  sense  the  final  goal  of  accounting  in  any  case 
is  the  net  revenue  figure.  It  is  net  revenue  (or  net  loss)  which 
measures  the  change  in  the  status  of  the  private  equities  during 
a  given  period.  It  is  this  amount  which  reflects  the  ownership 
phase  of  the  results  of  the  business  process.  Increase  in  wealth 

-  which  is  measured  in  the  accounts  by  the  net  revenue  figure 

-  is  the  purpose  of  the  business  enterprise  from  the  standpoint 
of  the  individual  owners.     Since  the  accounts  are  kept  primarily 
from  this  standpoint  it  might  be  said  that  nearly  all  questions 
of  accounting  analysis  center  around  the  determination  of  net 
revenue. 

220 


DETERMINATION  OF  NET  REVENUE       221 

The  net  revenue  figure  is  the  amount  available  for  partition 
among  the  various  individuals  and  interests  that  furnish  the 
capital  in  any  case.  It  may  not  always  be  either  expedient  or 
possible,  however,  to  withdraw  this  sum  in  cash  or  an  equivalent. 
(See  the  following  section.)  In  such  an  event  net  revenue  may 
be  retained  as  new  investment,  each  equity  account  being 
credited  with  its  proper  share.  A  partnership,  for  example, 
shows  in  its  accounts  a  net  revenue  of  $10,000  for  the  year. 
Assuming  that  there  are  no  liabilities  on  which  interest  accrues 
this  amount  is  available  for  division  among  the  partners,  A  and 
B.  It  may  be,  however,  that  the  demands  upon  the  firm's 
current  assets  because  of  the  need  for  additional  equipment  are 
so  great  that  there  is  little  cash  available  for  dividends.  Further, 
it  may  be  that  it  would  be  unwise  to  borrow  at  this  time.  If 
such  is  the  case  the  net  revenue  figure  may  be  disposed  of  by 
credits  to  the  partners'  accounts  in  accordance  with  the  articles 
of  copartnership. 

It  is  particularly  important  that  net  revenue  be  accurately 
determined  at  the  end  of  each  accounting  period  in  the  case  of 
a  business  organization  which  acquires  its  capital  from  several 
distinct  classes  of  investors.  (See  Chapter  I.)  A  particular 
corporation,  for  example,  may  have  outstanding  as  equities 
not  only  stocks,  bonds,  and  notes,  but  several  types  of  stocks 
and  bonds.  If  net  revenue  is  not  accurately  determined  each 
year  not  only  are  transient  individual  owners  likely  to  be  mis- 
led but  the  interests  of  an  entire  class  of  investors  such  as  the 
income  bondholders,  for  example,  may  be  jeopardized.  In  the 
case  of  a  small  single-proprietorship,  on  the  other  hand,  where 
practically  the  entire  investment  is  the  proprietor's,  this  prob- 
lem of  equities  does  not  arise. 

In  so  far  as  net  revenue  summarizes  the  results  of  the  efforts 
of  the  operating  management  and  the  employees,  this  figure 
may  be  used  for  comparative  purposes  as  a  rough  test  for  effi- 
ciency. If  net  revenue  be  broadly  defined,  however,  as  repre- 
senting the  net  change  in  the  status  of  the  equities,  this  figure 
cannot  as  a  rule  be  said  to  show  merely  the  results  of  operation 
in  the  technical  sense.  The  speculative  accidents  of  the  situa- 
tion are  also  involved.  This  topic  will  be  further  discussed  in 
a  later  section  of  this  chapter. 


222  PRINCIPLES  OF  ACCOUNTING 

The  nature  of  net  revenue  and  its  relation  to  the  other  funda- 
mental concepts  of  accounting  was  explained  in  Chapter  III. 
In  this  connection  it  will  be  desirable  to  review  this  matter 
briefly.  The  business  enterprise  secures  from  the  various  in- 
vestors a  sum  of  cash  or  an  equivalent.  These  funds  are  in- 
vested in  plant,  equipment,  raw  materials,  etc.  To  work  up 
the  raw  material  into  a  finished  product  it  is  necessary  to  hire 
laborers,  buy  supplies,  and  secure  other  commodities  and  services. 
All  such  items  are  purchased  with  part  of  the  original  cash,  with 
new  capital,  or  on  credit.  As  production  is  accomplished  sales 
are  made  of  the  finished  product  and  current  assets  such  as  cash, 
accounts  receivable,  etc.,  are  received  in  exchange.  As  these 
current  assets  become  cash  they  may  be  used  again  to  buy  more 
material  and  the  other  necessary  commodities  and  services. 
Ignoring  price  changes  it  might  be  said  that  the  excess  of  all 
assets  received  from  sales  (and  from  speculative  and  accidental 
opportunities)  within  a  given  accounting  period,  over  the  amount 
of  fixed  assets  expired,  materials  used,  and  other  commodities 
and  services  consumed  in  producing  these  sales  (or  otherwise 
destroyed)  constitutes  net  revenue.  It  is  the  return  to  the 
investor  for  the  services  he  performs  —  a  remuneration  for  the 
burden  of  ownership.  In  the  accounts  this  amount  is  repre- 
sented by  the  balance  of  the  expense  and  revenue  accounts. 

Net  revenue  is  a  part  of  the  economist's  "cost  of  production." 
At  least  it  is  a  component  of  the  price  which  the  consumer  pays. 
It  is  not,  however,  nor  any  portion  of  it,  an  expense  of  the  busi- 
ness enterprise.  The  confusion  of  expense  and  economic  cost 
is  one  of  the  most  common  errors  made  by  accountants.  An 
expense  arises  because  of  the  expiration  of  some  commodity 
or  service  purchased  by  the  enterprise.  The  enterprise  does 
not  buy  the  services  of  the  owners.  Nor  does  any  one  owner 
such  as  the  stockholder  buy  the  services  of  other  owners  such 
as  bondholders.  Rather  it  may  be  said  that  each  investor 
furnisJies  his  service  in  anticipation  of  a  return  on  his  investment 
due  to  the  fact  that  revenues  normally  exceed  expenses.  In 
other  words  interest  and  dividends  are  in  essentially  the  same 
accounting  category,  as  was  previously  explained,  and  are 
charges  against  net  revenue  rather  than  gross  revenue. 

The  nature  of  the  service  which  the  investor  furnishes  differs 


DETERMINATION  OF  NET  REVENUE       223 

widely  in  various  enterprises.  In  single-proprietorships  and 
partnerships  the  proprietors  often  not  only  assume  the  manage- 
ment of  the  enterprise  but  furnish  a  large  part  or  even  all  of  the 
ordinary  labor  services  as  well.  In  such  a  case  net  revenue  is 
clearly  not  synonymous  with  the  interest  and  profit  of  economic 
theory.  The  four  principal  distributive  shares,  wages,  rent, 
interest,  and  pure  profit,  may  all  be  represented.  In  the  cor- 
poration, on  the  other  hand,  labor  services  and  management 
may  be  purchased  for  the  most  part  from  individuals  who  furnish 
no  capital  and  hence  do  not  have  equities  in  the  enterprise  in 
the  ordinary  sense.  It  is  often  urged  that  accounts  should  be 
set  up  which  charge  as  expense  a  reasonable  return  for  the 
proprietor's  labor  and  a  reasonable  interest  allowance  for  the 
capital  he  furnishes.  Such  fictitious  accounts  are  practically 
useless,  and  usually  do  more  to  confuse  the  owner  than  to  instruct 
him.  If  the  proprietor  works  in  his  store  from  six  o'clock  in 
the  morning  until  ten  at  night  he  is  perfectly  well  aware  of  that 
fact.  What  he  wishes  to  know  is  the  return  he  is  making  on 
his  business  and  his  efforts.  If  this  return  does  not  give  him  a 
reasonable  rate  on  his  investment  and  decent  wages  for  his 
work  he  does  not  need  a  special  ledger  account  to  tell  him  that 
fact.  For  the  purposes  of  financial  accounting  there  is  little 
need  of  separating  net  revenue  into  its  economic  elements. 

Further,  the  use  of  fictitious  expense  accounts,  if  actual  errors 
are  avoided,  does  not  affect  the  net  revenue  figures.  Suppose, 
for  example,  that  an  "expense"  account,  Interest  on  Capital 
Owned,  be  charged  with  an  amount  equal  to  six  per  cent  on  the 
investment.  In  what  account  is  the  concurrent  credit  incident  ? 
Clearly  some  revenue  account  must  be  credited  with  the  same 
amount;  and  this  procedure  does  not  affect  the  net  revenue 
figure  in  any  way.  If  an  account  in  some  other  classification  is 
credited  the  net  revenue  figure  will  not  be  correctly  stated. 

In  connection  with  income  taxes  cases  arise  in  which  the  use 
of  fictitious  expense  accounts  seems  at  least  partially  justified. 
A  particular  tax,  for  example,  may  be  levied  upon  net  proprietary 
income,  and  may  fall  upon  all  types  of  business  organizations 
without  discrimination.  In  such  a  case  the  corporation  which 
buys  labor  services  and  management  has  an  advantage  over 
the.  single-proprietorship  where  the  proprietor  is  at  once  in- 


224  PRINCIPLES  OF  ACCOUNTING 

vestor,  manager,  and  common  laborer.  In  the  case  of  the 
corporation  the  stockholder's  dividend  may  be  largely  interest 
and  pure  profit.  In  the  case  of  the  single-proprietorship  the 
proprietor's  net  income  may  be  in  large  measure  wages.  To 
avoid  injustice  in  such  cases  it  would  seem  reasonable  to  allow 
the  proprietor  in  the  small  concern  to  charge  expense  with  a 
reasonable  salary  for  his  own  services.  If  he  does  not  with- 
draw this  salary  in  cash,  however,  the  corresponding  credit 
should  be  entered  in  a  surplus  or  other  proprietary  account. 
This  transaction  can  be  conceived  in  this  way :  one  expense  of 
running  the  business  is  the  salary  of  the  manager  who  is  also 
an  owner ;  but  instead  of  withdrawing  this  salary  the  proprietor 
immediately  invests  this  amount  in  the  business.  Such  a  transac- 
tion does  not  reduce  the  proprietor's  return.  It  simply  divides 
his  income  between  wages  and  return  to  capital. 

In  general  it  is  unwise  to  attempt  in  the  accounts  to  divide 
either  total  net  revenue  or  net  proprietary  income  into  its  eco- 
nomic elements.1  This  is  a  part  of  the  individual  investor's 
economy ;  and  it  can  be  safely  left  to  the  individual. 


THE   CASH  STATEMENT 

The  expense  and  revenue  statement  should  exactly  represent 
the  operating  situation  for  a  particular  accounting  period.  That 
is,  this  statement  should  show  revenues  and  expenses  accrued  in 
the  fiscal  period  just  past.  All  commodities  and  services  con- 
sumed in  the  period  constitute  the  total  expense ;  all  revenues 
earned  during  the  period  constitute  total  revenue.  Thus  a 
distinction  should  be  sharply  drawn  between  statements  of  cash 
receipts  and  expenditures,  and  of  expenses  and  revenues. 

This  point  needs  further  elaboration,  for  in  actual  practice 
the  distinction  is  not  always  recognized.  Particularly  in  munici- 
pal enterprises  is  the  treasurer's  report  accepted  in  lieu  of  an 
expense  and  revenue  statement.  In  most  cities  the  statement 
from  which  the  budget  for  the  ensuing  fiscal  period  is  prepared 

1  In  cost  accounting  problems  arise  which  involve  the  computation  of  interest 
on  investment  as  a  cost.  It  is  doubtful  even  in  such  cases,  however,  if  such  compu- 
tations should  be  set  up  in  the  accounts.  See  Chapter  XXIX. 


DETERMINATION  OF  NET  REVENUE       225 

is  that  of  receipts  and  disbursements.  This  is  merely  a  state- 
ment of  cash  received  and  paid  out  during  the  year  —  in  other 
words  an  itemized  Cash  account.  It  reflects  the  stewardship 
of  the  officers  in  regard  to  one  kind  of  property  —  cash.  This 
is  clearly  not  the  same  information  as  that  shown  by  an  expense 
and  revenue  statement.  Cash  disbursements  and  expenses  are 
not  synonymous  terms.  Payments  are  often  made  for  perma- 
nent improvements  which  are  not  expenses.  Disbursements 
may  be  made  in  one  year  to  cover  the  expenses  of  a  previous 
year.  Similarly,  the  expenses  of  a  particular  period  often  do 
not  appear  among  the  current  disbursements,  but  will  be  paid 
in  later  periods.  Further,  certain  expenses  may  not  involve 
expenditure  for  years,  if  ever.  An  example  of  such  an  expense 
is  the  depreciation  of  durable  property.  Depreciation  may  be 
regularly  charged  to  operating  expense  and  yet  no  replacements 
may  occur  for  a  long  period.  The  situation  in  regard  to  revenue 
earned  as  compared  with  cash  receipts  is  analogous. 

An  illustration  will  perhaps  make  the  distinction  between  these 
different  kinds  of  information  entirely  clear.  The  officials  of 
an  urban  water  company  petition  the  city  council  that  the 
company  be  allowed  to  raise  the  rates  to  its  customers.  They 
urge  that  the  company  is  being  operated  at  a  deficit,  and  fur- 
nish, to  support  their  contention,  the  following  statement  of 
receipts  and  disbursements : 


THE  A.  Co.,  December  31,  1917 
Receipts 

Cash  on  hand  December  31,  1916 $21,400 

Quarterly  Rates $33>Q67 

Metered  Water 14,722 

Mason  Work 

Metered  Rentals        

Miscellaneous        

Bank  Loan  

Sale  of  Abandoned  Property        

Total  Receipts  for  the  year 56,266 

$77,666 


226  PRINCIPLES  OF  ACCOUNTING 

Disbursements 
Operation: 

Pumping  Station  Expense        $  6,402 

Fuel 5,061 

Office  and  Distribution  Expense        10,072 

Rebates  and  Stoppages        605 

Maintenance: 

Repairs  to  Distribution        607 

Repairs  to  Pumping  Station 644 

Repairs  to  Meters      .     .     .     .  * 581 

Interest  on  Bonds 1 5,000 

Sinking  Fund  Installment        15,000 

New  Extension 18,000 

Insurance , 414 

Total  Disbursements  for  the  year 72,386 

Cash  on  hand  December  31,  1917 $  5,280 

On  the  basis  of  the  above  figures  the  company  contends  that 
the  water  plant  has  been  operated  at  a  deficit  for  the  year  of 
$16,120  (the  shrinkage  in  cash),  and  asks  that  the  water  rates 
be  raised. 

A  careful  examination  of  the  items  in  this  statement  will 
serve  to  throw  some  light  upon  the  propriety  of  the  company's 
petition.  All  of  the  items  shown  among  the  receipts  of  the 
current  year  appear  to  be  from  revenue  sources  with  two  ex- 
ceptions. The  amount  realized  from  the  sale  of  abandoned 
property  is  evidently  not  a  revenue;  it  represents  a  receipt 
from  the  sale  of  part  of  the  capital  equipment,  and  it  is  likely 
that  a  large  element  of  expense  is  involved  in  the  transaction. 
And  the  amount  borrowed  from  a  bank  is  not  a  revenue ;  revenue 
cannot  be  earned  by  borrowing.  Among  the  disbursements  the 
sinking  fund  installment  clearly  does  not  represent  expense. 
Sinking  Fund  is  not  an  expense  account,  but  represents  rather  a 
special  fund  of  assets  set  aside  to  redeem  bonds  or  for  some  other 
purpose.  Even  if  this  fund  were  immediately  used  to  retire 
some  equity  the  expenditure  would  in  nowise  be  an  expense 
charge.  Revenue  cannot  be  earned  by  contracting  debts ; 
neither  is  expense  incurred  by  paying  debts.  "  New  Extension, 
$18,000  "  represents  quite  evidently  an  expenditure  for  capital 
improvements,  and  hence  should  not  be  included  among  the 


DETERMINATION  OF  NET  REVENUE       227 

expense  items.  Further,  the  amount  paid  as  bond  interest 
represents  a  distribution  of  either  net  revenue  or  capital  to  a 
contractual  equity,  and  hence  cannot  be  considered  an  operating 
expense. 

The  following  table  represents  the  expense  and  revenue  state- 
ment for  the  year  constructed  from  the  cash  book  records  in 
accordance  with  the  above  suggestions : 

Revenue 

Quarterly  Rates $33,967 

Metered  Water 14,722 

Mason  Work 836 

Meter  Rentals 170 

Miscellaneous        71 

Total $49,766 

Expense 
Operation : 

Pumping  Station  Expense $  6,402 

Fuel 5,o6i 

Office  and  Distribution  Expense        10,072 

Rebates  and  Stoppages        605 

Maintenance : 

Repairs  to  Distribution        607 

Repairs  to  Pumping  Station 644 

Repairs  to  Meters 581 

Insurance 414 

Total 24,386 

Net  Revenue $25,380 

This  statement  shows  a  net  revenue  for  the  year  of  $25,380, 
as  compared  with  a  deficit  in  cash  of  $16,120.  After  the  interest 
charges  of  $15,000  are  met  there  remains  of  net  revenue  the 
amount  of  $10,380,  the  net  proprietary  income.  Although 
this  income  has  evidently  not  been  realized  in  cash  it  may  well 
be  that  it  amounts  to  a  fair  return  upon  the  stockholder's  in- 
vestment. 

The  above  expense  and  revenue  statement,  however,  is  prob- 
ably inaccurate.  Although  an  itemized  statement  of  receipts 
and  disbursements  gives  some  clue  to  expenses  and  revenues,  it 
is  not  possible  to  revise  any  cash  statement  in  such  a  way  as  to 
make  it  a  dependable  income  sheet.  Depreciation  for  the  year, 


228  PRINCIPLES  OF  ACCOUNTING 

for  example,  is  not  taken  into  consideration.  Further,  the 
statement  of  revenue  assumes  that  revenue  earned  during  the 
fiscal  period  coincides  with  cash  receipts  from  revenue  sources. 
This  is  a  very  unlikely  situation.  Doubtless  some  of  these 
receipts  represent  revenue  earned  in  the  preceding  period ;  and 
it  is  probable  that  the  receipts  do  not  include  all  the  revenues 
accrued  within  the  current  period.  No  doubt  an  analogous 
situation  exists  in  regard  to  the  expense  items.  This  emphasizes 
the  need  for  distinct  expense  and  revenue  records.  The  success 
or  failure  of  operation  for  a  given  fiscal  period  can  only  be  shown 
by  a  statement  of  revenue  earned  and  expense  accrued  in  that 
period.  The  excess  of  cash  received  over  cash  disbursed  for 
the  year,  or  vice  versa,  usually  bears  little  relation  to  net  revenue 
or  net  loss  for  the  period. 

DEFERRED   CHARGES   AND   CREDITS 

It  has  been  stated  above  that  the  expense  and  revenue  state- 
ment should  include  all  the  expenses  for  the  period  covered  by 
the  statement.  It  occasionally  seems  advisable,  however,  to 
treat  certain  extraordinary  charges  as  items  applying  not  solely 
to  the  particular  period  in  which  the  expense  is  first  recognized, 
but  to  several  periods.  Suppose,  for  example,  that  because  of 
rapid  changes  in  mechanical  technique,  an  electric  power  com- 
pany finds  a  number  of  dynamos  obsolete,  even  though  this 
property  has  suffered  little  physical  deterioration.  It  becomes 
necessary  to  replace  with  the  improved  types,  it  may  be  as- 
sumed, property  to  the  amount  of  $50,0x30  which  is  almost  new. 
Assuming  a  scrap  value  of  $8,000  this  means  an  expense  for  the 
year  of  $42,000.  The  management  may  with  reason  argue  that 
this  is  an  unusual  expense,  unlikely  to  occur  again,  or  at  least 
not  oftener  than  once  in  several  years.  Consequently  it  would 
seriously  distort  the  expense  and  revenue  statement  and  the 
resulting  net  revenue  figure  to  charge  the  entire  amount  into  the 
expense  of  a  single  year.  Therefore  it  is  decided  in  this  case  to 
charge  but  $10,000  of  this  expense  against  the  revenue  of  the 
current  year,  and  to  carry  $32,000  on  the  asset  side  of  the  balance 
sheet  as  a  deferred  expense.  This  may  be  considered  an  entirely 
legitimate  procedure ;  and  deferred  expense  items  are  very  fre- 


DETERMINATION  OF  NET  REVENUE       229 

quently  met  with  in  accounting  practice.  Such  items,  however, 
should  not  be  confused  with  the  assets.  A  deferred  expense  of 
this  type  is  not  an  asset,  but  a  deduction  from  the  equities  which 
the  management  has  not  been  willing  to  recognize  as  a  current 
deduction,  although  the  loss  has  actually  occurred.  The  desire 
to  preserve  financial  standing,  and  a  reasonably  even  flow  of 
income,  is  the  usual  excuse  for  such  deferred  items. 

The  following  is  a  somewhat  different  illustration.  A  firm  has 
been  involved  in  litigation  for  three  years.  The  company's 
lawyers  have  been  paid  nothing  but  retaining  fees.  The  case 
is  settled  and  the  lawyers  are  paid  $25,000.  It  seems  evident 
that  this  is  an  expense,  not  of  any  one  year,  but  of  the  three 
years.  If  it  were  possible  to  forecast  this  expenditure  the  most 
desirable  procedure  would  be  to  charge  the  revenue  of  each  year 
with  one-third  of  the  total  expense.  It  is  not  likely,  however, 
that  the  management  could  accurately  estimate  in  advance  the 
length  of  the  suit  or  its  cost.  In  this  event  the  item  —  when 
finally  paid  —  may  be  carried  as  a  deferred  expense  if  it  is  so 
large  as  to  seriously  affect  the  current  statement  of  income. 

The  final  disposition  of  these  deferred  expense  items  is  a 
matter  of  importance.  Such  charges,  evidently,  should  not  be 
carried  indefinitely  on  the  books,  but  should  be  transferred  as 
soon  as  convenient  to  current  revenue  or  to  accumulated  surplus. 
In  general  it  would  seem  best  to  close  these  balances  against 
annual  or  accumulated  surplus.  A  deferred  expense  is  really  a 
deduction  from  proprietorship  which  should  have  been  provided 
for  by  charges  to  revenue  during  the  years  in  which  the  loss 
might  be  said  to  be  accruing.  Since  this  was  not  done,  earlier 
income  sheets  have  been  incorrect  to  some  extent.  But  to  load 
these  charges  upon  the  results  of  operation  in  succeeding  periods 
would  seem  to  be  an  improper  method  of  making  the  correction. 
If  losses  accruing  in  previous  periods  are  charged  against  current 
revenue  a  new  error  is  made.  It  is  better  practice  to  dispose  of 
such  deferred  expense  balances  by  means  of  credits  to  the  de- 
ferred expense  account  and  charges  to  unappropriated  surplus. 

The  balance  sheet  of  almost  every  large  corporation  shows 
one  or  several  deferred  expense  items.  Chary  use  should  be 
made  of  such  accounts,  however,  and  only  in  unusual  circum- 
stances should  an  item  which  represents  an  actual  deduction 


230  PRINCIPLES  OF  ACCOUNTING 

from  equities  be  carried  in  suspense,  instead  of  being  charged 
against  current  revenue  or  present  surplus. 

Deferred  charges  —  so-called  —  of  a  different  type  from  the 
above  cases  frequently  occur.  Such  are  expenditures  for  services 
from  which  the  benefit  is  not  exhausted  for  a  long  period.  A 
common  illustration  is  the  expenditure  for  stripping  "over- 
burden" in  the  case  of  certain  kinds  of  mining  properties.  In 
the  porphyry  copper  mines  of  Nevada,  for  example,  the  earth 
-  which  may  be  many  feet  deep  —  must  be  removed  from  a 
large  area  before  the  actual  process  of  mining  the  ore  can  begin. 
Once  the  overburden  is  removed,  the  ore  is  mined  very  rapidly 
with  steam  shovels,  and  no  further  expenditure  need  be  in- 
curred for  stripping  as  far  as  that  portion  of  the  ore  body  is 
concerned.  It  may  take  one  or  two  years  to  remove  the  top 
earth ;  and  in  that  time  not  a  pound  of  ore  is  mined,  nor  a  cent 
of  revenue  received.  It  is  common  practice  in  such  a  case  to 
carry  the  costs  of  stripping  on  the  balance  sheet  as  a  deferred 
debit  item.  It  should  be  emphasized,  however,  that  such  an 
item  is  really  neither  an  expense  nor  a  loss,  but  rather  an  asset, 
representing  the  value  of  a  service  purchased  and  paid  for,  but 
not  yet  consumed.  It  is  an  expense  of  mining  all  the  ore  much 
as  all  capital  outlay  is  an  expense  of  earning  the  revenue  through- 
out the  life  of  the  property;  and  it  should  be  charged  as  an 
expense  currently,  in  proportion  to  the  weight  of  ore  mined,  reve- 
nue received  or  some  other  appropriate  basis,  in  the  same  manner 
as  any  expiration  of  property  due  to  business  operation  is  charged. 
Although  the  general  distinction  between  an  actual  deferred 
asset  and  an  expense  or  loss  is  clear,  it  is  sometimes  hard  to  draw 
the  line  in  specific  cases.  Suppose,  for  example,  that  a  firm 
maintains  a  department  for  the  purpose  of  making  tests  and 
experiments  with  a  view  to  developing  new  processes  and 
methods.  Are  the  necessary  expenditures  properly  chargeable 
to  an  asset  account,  or  should  they  be  considered  an  expense? 
In  so  far  as  such  a  department  is  a  permanent  adjunct  of  the 
business,  and  is  necessary  to  keep  the  firm  abreast  of  competi- 
tors, such  expenditures  are  clearly  expense  outlays  —  a  current 
cost  of  operation.  It  is  often  urged,  however,  that  if  the  experi- 
ments can  reasonably  be  expected  to  result  in  a  profitable  process 
the  costs  should  be  carried  as  a  deferred  asset  in  the  balance 


DETERMINATION  OF  NET  REVENUE       231 

sheet.  In  general  it  would  seem  more  reasonable  to  charge 
such  outlays  against  current  revenue  —  unless  the  net  revenue 
figure  is  thereby  seriously  distorted.  If  the  experiments  result 
favorably  it  will  be  time  enough  then  to  revise  the  analysis. 
At  that  time  the  value  of  the  process  itself,  or  of  the  patents 
representing  it,  can  be  placed  on  the  books  as  an  intangible  asset. 
In  many  balance  sheets  actual  losses  and  other  proprietary 
valuation  items  are  grouped  with  prepaid  services  under  the 
head  "deferred  debit  items,"  or  a  similar  caption.  This  practice 
seems  clearly  improper.  It  should  be  recognized,  however,  that 
it  is  not  possible  to  lay  down  hard  and  fast  rules  for  distinguish- 
ing between  these  dissimilar  facts  which  cover  all  cases.  The 
nature  of  each  deferred  charge  must  be  determined  in  view  of 
the  concrete  circumstances  giving  rise  to  the  charge.  Certainly 
in  analyzing  a  balance  sheet  all  such  items  should  be  carefully 
scrutinized. 

The  nature  and  treatment  of  prepaid  revenues  should  be 
briefly  considered  in  this  section.  An  illustration  will  perhaps 
serve  to  explain  the  significance  of  such  a  deferred  credit.  A 
water  transportation  company,  whose  boats  ply  to  and  from 
certain  resort  points,  sells  season  ticket  books  during  the  month 
of  May  amounting  to  $12,000.  In  this  month  tickets  are  taken 
up  having  an  aggregate  value  of  but  $5,000.  Ignoring  the  ques- 
tion of  selling  expense  it  is  evident  that  the  company  has  earned 
during  May  but  $5,000,  the  amount  of  the  cancelled  tickets. 
The  balance  of  the  tickets  sold  represents  a  deferred  revenue 

—  a  liability  item  of  the  nature  of  the  prepaid  rent  balance 
discussed  on  page  180.     The  company  is  still  obligated  to  fur- 
nish to  certain  individuals  services  with  a  selling  price  of  $7,000. 
The  entries  covering  these  transactions  —  in  summary  form 

-  would  be  somewhat  as  follows  : 

d) 

Cash $12,000 

Sales  of  Tickets $12,000 

(2) 

Sales  of  Tickets $5,ooo 

May  Revenue $5,ooo 


232  PRINCIPLES  OF  ACCOUNTING 

The  balance  of  the  Sales  of  Tickets  account  is  a  deferred  revenue 

—  a  liability  —  and  would  appear  as  a  deferred  credit  balance 
in  the  balance  sheet  prepared  on  May  3ist.     This  balance  is 
transferred  to  current  revenue  as  the  tickets  which  it  represents 
are  taken  up. 

Such  an  analysis  of  sales  is  not  of  great  importance  from  the 
standpoint  of  the  investors  provided  it  is  the  annual  statement 
of  net  revenue  which  is  used  as  a  basis  for  dividends  and  other 
appropriations.  From  the  manager's  standpoint,  however,  it 
is  essential  that  total  earnings  be  properly  apportioned  among 
the  various  operating  periods. 

Prepaid  revenues  are  not  as  common  in  business  practice  as 
are  revenues  earned  but  unpaid.  In  many  cases  a  company 
sells  the  finished  goods  in  advance  of  completion,  although  pay- 
ment is  not  made  until  delivery.  Extreme  instances  of  such 
contracts  are  found  in  such  industries  as  shipbuilding.  In 
these  cases  it  is  usually  considered  proper  for  the  company  to 
accrue  a  reasonable  proportion  of  the  total  revenue  in  each 
period,  even  if  no  payment  whatever  has  been  made.  In  any 
case  —  as  was  emphasized  in  a  preceding  section  of  this  chapter 

—  it  is  seldom  a  rational  procedure  to  follow  cash  transactions 
in  determining  current  revenue. 

Deferred  revenue  credits  are  sometimes  grouped  with  asset 
valuation  items  on  the  right-hand  side  of  the  balance  sheet.  This 
practice  is  not  a  desirable  one,  as  prepaid  revenues  and  offsets  to 
assets  are  in  nowise  congruous  items. 

WASTING  ASSETS 

Practically  all  kinds  of  assets  expire  in  business  operation, 
but  many  types  of  property  are  of  such  a  character  that  they 
cannot  be  replaced  concurrently  with  the  expirations,  if  at  all. 
Such  properties  are  mines,  forests,  and  other  natural  resources, 
and  properties  arising  from  terminable  state  or  private  grants 
such  as  patents,  copyrights,  franchises,  leases,  etc.  Consider, 
for  example,  the  case  of  a  mine.  Every  pound  of  ore  removed 
lessens  the  value  of  the  property  (assuming  that  there  is  no 
change  in  current  costs  or  in  the  price  of  the  product).  A  par- 
ticular corporation  may  be  able  to  acquire  new  property  of  a 


DETERMINATION  OF  NET  REVENUE       233 

similar  nature,  but  frequently  this  is  not  possible.  Then  in 
such  a  case  if  revenue  is  retained  in  the  business  to  cover  the 
decline  in  capital  assets,  it  must  be  retained  in  the  form  of  cash 
or  other  liquid  funds.  It  is  common  practice,  however,  to  return 
the  capital  to  the  stockholders  in  the  form  of  dividends  as  the 
property  expires.  In  such  a  case  the  dividend  amount  should 
be  carefully  apportioned  between  net  income  and  the  return 
of  the  original  investment.  Otherwise,  as  is  frequently  the 
case,  a  serious  misstatement  of  net  revenue  results.  Often  the 
stockholder  considers  his  dividend  check  as  representing  pure 
income,  and  later,  to  his  surprise,  he  discovers  that  his  original 
investment  has  disappeared.  It  is  imperative  that  if  all  prop- 
erty expirations  are  not  included  in  the  expense  charges  the 
residuum  from  the  expense  and  revenue  statement  shall  not  be 
considered  as  net  revenue,  and  that  if  this  figure  be  paid  as 
dividends  it  shall  be  carefully  apportioned  between  net  revenue 
and  capital  return.  This  analysis  should  be  made  on  the  financial 
records  of  both  the  corporation  and  the  stockholder. 

Although  in  some  cases  the  nature  and  extent  of  the  ore  body 
may  be  estimated  with  reasonable  accuracy  from  the  results  of 
preliminary  drilling,  in  vein  mines  it  is  often  exceedingly  difficult 
to  determine  by  exploration  the  size  or  character  of  the  mineral 
deposits.  In  such  cases  it  may  be  urged  that  it  is  not  feasible 
to  amortize  the  cost  of  the  mine  itself  by  charges  against  revenue. 
The  venture  is  a  highly  speculative  one ;  and  the  owners  under- 
stand the  risks.  Accordingly  no  purpose  is  served  by  attempt- 
ing to  write  down  the  capital  assets.  The  size  and  character  of 
the  ore  body  are  largely  matters  of  guess ;  new  deposits  are 
being  continually  discovered ;  old  veins  are  found  to  be  faulted. 
Hence  there  is  no  rational  basis  for  estimating  such  depreciation 
charges.  Even  in  such  cases,  however,  it  would  be  a  conserva- 
tive policy  to  charge  a  reasonable  allowance  for  expired  capital 
against  each  year's  revenues.  Experience  has  demonstrated 
that  such  properties  do  not  last  indefinitely.  In  any  case  the 
depreciation  of  equipment  —  shaft,  power-plant,  etc.  —  should 
of  course  be  regularly  recognized  by  charges  against  revenue. 

In  some  cases  the  physical  expiration  of  assets  in  a  wasting 
enterprise  may  be  quite  easily  measured.  A  lumbering  com- 
pany, for  example,  may  be  organized  for  the  specific  purpose  of 


234  PRINCIPLES   OF   ACCOUNTING 

cutting  the  timber  on  a  given  tract.  The  value  of  the  timber 
removed  each  year  —  on  a  cost  basis  —  could  be  estimated 
with  approximate  accuracy.  It  might  seem  that  this  amount 
—  in  addition  to  running  expenses  —  should  be  charged  against 
gross  sales  each  year  if  net  revenue  is  to  be  correctly  stated. 
The  problem  of  interest  is  involved  in  the  valuation  of  such  a 
property,  however,  in  much  the  same  way  as  in  the  case  of  a 
regular  annuity.  Hence  the  "present  value  of  future  revenue 
method  "  is  the  most  logical  device  for  measuring  the  deprecia- 
tion of  such  a  terminable  property.  This  and  other  methods 
of  measuring  depreciation  will  be  discussed  in  Chapter  XXIII. 
Patents,  copyrights,  leases,  etc.,  are  similarly  assets  which 
cover  definite  periods  and  which  should  be  depreciated  in  each 
case  during  the  life  of  the  asset  by  charges  against  revenue. 
All  such  rights  and  privileges  expire  in  time  and  often  cannot 
be  replaced  in  kind.  The  amount  of  the  expiration  in  each 
case  must  be  treated  as  an  expense  and  included  among  the 
current  charges.  If  capital  retained  by  such  charges  is  returned 
to  the  stockholder,  this  fact  should  be  recognized  in  the  accounts. 
The  accounting  treatment  of  such  intangibles  will  be  further 
discussed  in  later  chapters. 

MAINTENANCE   AND  IMPEOVEMENT 

The  problem  of  ascertaining  whether  a  given  expenditure 
represents  a  repair  or  a  renewal  (and  hence  is  an  expense  charge) , 
or  whether  it  represents  an  improvement  (and  hence  is  a  capital 
outlay),  is  often  a  serious  one.  Particularly  in  the  case  of  complex 
properties  such  as  railroads  it  is  sometimes  a  very  difficult  matter 
to  draw  the  line  between  maintenance  and  improvement.  This 
problem  has  been  rendered  unnecessarily  involved  because  of  the 
common  tendency  among  accountants  and  operating  officials  to 
confuse  physical  and  value  facts.  When  it  is  once  clearly  recog- 
nized that  accounting  is  concerned  primarily  with  the  value 
representations  of  things,  part  of  the  difficulty  disappears.  It  is 
not  the  physical  object  which  appears  in  the  accounts  in  any 
case,  but  rather  the  value  of  the  object.  In  other  words,  the 
technical  nature  of  a  productive  instrument  has  accounting 
significance  only  as  it  conditions  the  value  of  the  instrument. 


DETERMINATION  OF  NET  REVENUE       235 

If  a  machine  which  cost  $5,000,  for  example,  and  has  been  carried 
on  the  books  since  the  date  of  purchase  at  that  figure,  is  replaced 
by  another  machine  of  like  physical  efficiency  but  which  costs 
$6,000,  it  would  seem  evident  that  $1,000  of  the  new  expenditure 
represents  a  capital  outlay.  It  is  true  that  no  more  physical 
product  is  produced  by  the  new  machine  than  by  the  old ;  but 
it  is  also  true  that  the  investment  now  necessary  for  the  pro- 
duction of  the  particular  product  involved  is  $6,000.  To  show 
this  new  figure  in  the  financial  records  is  simply  tardy  recogni- 
tion of  the  fact  that  the  capital  cost  of  producing  a  certain 
commodity  or  service  has  increased.  The  proper  journal  entries 
covering  the  above  transaction  would  therefore  be  : 1 

d) 

Expense $5,ooo 

Machine  No.  i $S,ooo 

(2) 

Machine  No.  2 $6,000 

Cash     .     . $6,000 

The  accounts  should  always  show  the  present  value  of  the 
property  being  used  by  an  enterprise  in  producing  its  product 
if  statistics  drawn  from  the  accounts  are  to  furnish  the  manager 
with  the  information  which  will  enable  him  to  make  rational 
use  of  the  economic  resources  at  his  disposal.  According  to 
this  view  the  new  machine  mentioned  above  would  be  entered 
in  the  accounts  at  $6,000  even  if  its  physical  efficiency  were  less 
than  that  of  the  old  machine.  Or  if  the  new  machine  were  of 
an  improved  type  and  cost  less  or  more  than  the  original  ma- 
chine, it  should  in  any  case  be  entered  on  the  books  at  its  cost 
new.  The  fact  that  ninety-pound  rails  are  used  to  replace 
seventy-pound  rails,  for  example,  does  not  tell  those  interested 
whether  the  property  is  being  maintained  or  whether  an  improve- 
ment is  being  made.  The  question  is :  what  is  the  capital 
outlay  necessary  to  make  this  replacement  ?  If  the  new  expendi- 
ture is  greater  than  the  cost  of  the  old  equipment,  the  difference 
represents  an  addition  to  capital ;  if  the  necessary  expenditure 

1  These  entries  are  made  according  to  the  "  replacement  policy  "  of  handling 
depreciation.  See  Chapter  XXII. 


236  PRINCIPLES  OF  ACCOUNTING 

is  less  than  the  old  cost,  then  the  investment  in  the  particular 
property  item  involved  is  less  than  before. 

Even  if  it  be  decided  to  adopt  the  above  position,  there  are 
in  many  cases  practical  difficulties  in  the  way  of  determining 
just  where  to  draw  the  line  between  repairs  and  replacements, 
and  improvements  or  betterments.  In  connection  with  the 
upkeep  of  a  complex  piece  of  property,  where  there  is  no  test 
of  market  price  available,  it  may  be  almost  impossible  to  deter- 
mine accurately  which  outlays  are  actually  expenses  and  which 
are  capital  charges.  Repairs  (so-called)  to  a  factory  building, 
for  example,  may  be  so  extensive  as  actually  to  increase  the 
value  of  the  building,  but  it  may  be  very  hard  to  determine  just 
what  is  the  amount  of  the  improvement.  Arbitrary  estimates 
and  rules  are  necessary  in  such  cases.  Such  estimates  should, 
of  course,  be  based  on  all  available  information  in  each  particular 
case.  Approximate  accuracy  is  all  that  can  be  hoped  for  in 
most  instances.  The  rules  of  the  Interstate  Commerce  Com- 
mission in  connection  with  the  maintenance  of  steam  railway 
properties,  for  example,  formerly  prescribed  that  no  specific 
expenditures  of  less  than  $200  should  be  considered  as  chargeable 
to  additions  and  betterments.  Under  this  ruling  some  small 
improvements  were  wrongly  charged  to  expense ;  but  it  was  ex- 
pected that  errors  in  the  other  direction  would  approximately 
offset  any  such  charges. 

In  any  industry  in  which  improvements  in  mechanical  tech- 
nique are  taking  place  very  rapidly,  and  where  it  is  the  practice 
to  charge  all  repairs  and  renewals  in  the  technical  sense  to  ex- 
pense, overstatement  of  expense  and  understatement  of  capital 
is  quite  likely  to  result.  This  has  been  the  situation  in  the  case 
of  many  American  railway  properties.  Old  locomotives  were 
scrapped  and  replaced  with  more  efficient  and  more  costly  types, 
and  the  entire  cost  of  the  new  equipment  was  considered  as  a 
replacement.  Such  a  practice  results  in  what  are  called  secret 
reserves.  Such  a  reserve  is  an  item  of  proprietorship  which  repre- 
sents profits  retained  in  the  business,  but  which  does  not  appear 
on  the  balance  sheet  because  the  property  is  understated  by 
just  the  amount  of  the  reserve.  This  practice  is  entirely  illegiti- 
mate. It  may  not  mean  as  direct  a  step  toward  financial  disaster 
as  the  opposite  error  —  the  overstatement  of  property  and  the 


DETERMINATION  OF  NET  REVENUE       237 

understatement  of  expense  —  but  the  individual  stockholder  is 
misled  and  often  suffers  from  such  a  practice.  Further,  ac- 
counts which  do  not  represent  at  least  approximately  the  actual 
situation  cannot  serve  the  purposes  of  management  for  which 
financial  statistics  are  intended.  It  should  be  observed  that 
the  practice  of  charging  improvements  to  expense  followed  by 
some  railroad  companies  in  their  early  history  did  not  in  every 
case  lead  to  the  understatement  of  total  assets ;  for  in  many 
cases  the  original  property  figures  were  much  too  large.  In 
such  a  case  an  overstatement  of  expense  means  that  profits  are 
being  retained  in  the  business  —  although  this  is  not  recognized 
as  such  in  the  accounts  —  and  are  building  up  a  previously 
overstated  property ;  or,  in  other  words,  overcharges  to  expense 
are  making  good  equities  which  have  been  only  nominal  up  to 
this  time. 

It  might  be  said  at  this  point  that  it  is  the  practice  of  many 
banking  institutions  to  understate  or  to  omit  entirely  from  the 
accounts  such  assets  as  real  estate  and  furniture  and  fixtures, 
and  in  this  way  to  create  secret  reserves.  While  it  is  essential 
that  a  banking  house  be  conservative  in  its  accounting  practices 
it  is  doubtful  if  such  a  procedure  even  in  the  case  of  banks  is  in 
any  way  justified.  Sheer  understatement  where  it  is  possible 
to  ascertain  the  actual  facts  is  not  conservatism  but  conceal- 
ment ;  and  it  hardly  seems  as  if  any  proper  purposes  were  served 
by  such  accounting.  Certainly  in  some  cases  secret  reserves 
have  been  built  up  by  those  in  control  for  the  express  purpose 
of  defrauding  minority  owners.  Usually  the  interests  of  the 
various  equities  involved  are  best  protected  if  all  the  assets  — 
in  as  far  as  they  can  be  ascertained  —  are  shown  in  the  accounts. 
If  actual  assets  are  charged  against  revenue,  net  revenue  is  not 
correctly  stated,  and  erroneous  conclusions  will  be  drawn  by  the 
stockholders  and  others  concerned.  If  assets  are  concealed  by 
charges  to  surplus,  the  operating  sheet  may  be  correct,  but  an 
equity  is  misstated  in  the  balance  sheet ;  and  again  the  situation 
is  misleading  to  the  individual  owners. 

Probably  repairs  and  renewals  are  more  often  charged  to 
property  than  are  improvements  charged  to  expense.  The 
desire  on  the  part  of  the  management  in  a  particular  case  to 
make  a  good  showing  of  net  revenue  is  often  responsible  for 


238  PRINCIPLES  OF  ACCOUNTING 

such  a  procedure.  Frequently,  however,  this  is  done  because 
an  error  is  made  in  the  analysis  of  expenditures.  Expenditures 
which  are  made  for  the  purpose  of  earning  the  revenue  of  a 
single  fiscal  period,  and  which  represent  no  value  at  the  end 
of  that  period,  must  be  carefully  distinguished  from  expenditures 
which  mean  a  relatively  permanent  improvement.  An  amuse- 
ment company,  for  example,  furnishes  a  skating  rink  in  the 
winter  and  a  swimming  pool  in  the  summer  with  practically 
the  same  property  equipment.  Each  seasonal  change,  however, 
requires  some  expenditures  for  reconstruction.  These  outlays, 
obviously,  are  not  property  charges,  but  represent  current  ex- 
penses. If  these  items  were  considered  as  improvements  each 
season  the  value  of  the  property  would  soon  be  seriously  inflated. 
From  the  standpoint  of  financial  integrity  the  error  of  charg- 
ing repairs  and  renewals  to  property  is  more  serious  than  a  prac- 
tice which  leads  to  secret  reserves.  Errors  in  either  direction, 
however,  are  serious  from  the  standpoint  of  proper  accounting, 
and  should  be  avoided  as  far  as  possible. 

APPRECIATION  AND   DEPRECIATION 

If  the  net  revenue  be  defined  very  broadly  as  the  net  increase 
in  the  equities  during  a  given  period  (allowing  for  new  invest- 
ment and  capital  withdrawals),  it  is  clear  that  this  figure  can 
only  be  discovered  when  all  value  changes  are  taken  into  con- 
sideration. According  to  this  conception  of  net  revenue  the 
accrued  depreciation  of  fixed  assets  —  as  well  as  the  expirations 
due  to  the  consumption  (or  loss)  of  specific  units  of  commodities 
and  services  —  constitutes  a  part  of  the  total  expense  for  a 
given  period.  Similarly  all  appreciation  of  the  durable  equip- 
ment and  other  assets  during  an  accounting  period  —  as  well  as 
accruals  from  the  sale  of  product  —  is  a  part  of  total  revenue. 
Not  until  all  these  variations  in  asset  values  have  been  recog- 
nized can  the  new  status  of  the  equities  be  determined. 

In  so  far  as  depreciation  and  appreciation  are  normal  results 
of  business  operation  within  a  given  period  such  value  changes 
may  be  reflected  in  the  expense  and  gross  revenue  accounts. 
If  these  changes  are  unusual,  however,  or  apply  to  several  past 
accounting  periods,  the  Net  Revenue  and  Surplus  accounts 


DETERMINATION  OF  NET  REVENUE       239 

may  be  used  to  show  the  necessary  equity  adjustments.  Sup- 
pose, for  example,  that  a  manufacturing  company  has  a  building 
valued  at  $10,000  destroyed  by  an  unusual  storm.  The  entries 
might  be  as  follows : 

Surplus $10,000 

Buildings $10,000 

If  this  loss  were  considered  as  a  current  deduction  from  owner- 
ship the  entries  would  be : 

Net  Revenue $10,000 

Buildings $10,000 

Still  another  procedure  would  be  to  charge  a  special  account  such 
as  "Storm  Loss."  If  no  net  revenue  or  surplus  balances  were 
available  this  account  might  be  carried  as  a  deferred  expense  as 
explained  in  a  preceding  section. 

In  a  sense  items  of  appreciation  are  always  net  revenue  credits, 
for  no  deductions  are  involved  as  in  the  case  of  ordinary  revenues. 
Suppose  a  factory  site,  for  example,  appreciates  to  the  amount 
of  $5,000  during  an  accounting  period.  The  following  entries 
would  recognize  this  occurrence  : 

Real  Estate $5,ooo 

Net  Revenue $S,ooo 

If  such  an  item  of  appreciation  covers  several  accounting  periods 
before  it  is  recognized  in  the  accounts,  it  should  be  credited  not 
to  Net  Revenue  but  to  Surplus,  thus : 

Real  Estate $5,ooo 

Surplus $S,ooo 

For  in  this  case  crediting  the  amount  of  appreciation  to  Net 
Revenue  would  distort  the  current  figure.  In  the  meantime 
some  of  the  individual  owners  may  have  retired  from  the  enter- 
prise without  receiving  their  full  rights  in  property,  but  this 
situation  cannot,  of  course,  be  remedied.  The  most  adequate 
procedure,  then,  is  to  make  this  adjustment  through  the  surplus 
accounts. 

If  it  seemed  desirable  to  show  the  above  mentioned  item  of 


240  PRINCIPLES  OF  ACCOUNTING 

appreciation  in  distinct  net  revenue  and  property  accounts, 
entries  somewhat  as  follows  would  be  made : 

Appreciation  of  Real  Estate $5,000 

Net  Revenue  from  Appreciation  .     .  $5,000 

Where  items  of  appreciation  are  large  it  is  no  doubt  best  to 
adopt  this  or  a  similar  procedure ;  for  by  the  use  of  such  special 
accounts  the  nature  of  the  transaction  is  definitely  shown  in  the 
accounts.  In  any  case,  however,  the  explanation  of  the  occur- 
rence may  be  found  in  the  details  of  the  original  journal  entry. 

It  might  be  objected  that  the  conception  of  net  revenue  here 
developed  is  improper  in  that  it  apparently  obscures  the  results 
of  actual  operation  by  combining  in  one  figure  net  operating 
revenue  and  accruals  due  to  price  changes.1  This  objection  is 
not  of  great  importance.  As  a  matter  of  fact  this  analysis 
does  not  mean  that  no  differentiation  is  possible  in  the  financial 
records  between  the  results  of  actual  operation  and  the  results 
of  the  speculative  opportunities  and  burdens  involved  in  a 
business  enterprise.  It  is  quite  possible  to  organize  the  ac- 
counts and  statements  in  such  a  way  as  to  reveal  both  net 
revenue  from  operation,  so-called,  and  total  net  revenue  as 
well.  In  this  connection  it  should  be  noted  that  the  figure 
which  the  accountant  considers  as  net  operating  revenue  — 
the  result  of  purchase  and  sale  transactions,  and  ordinary  ac- 
cruals —  is  not,  in  most  cases,  restricted  to  the  results  of  opera- 
tion as  distinct  from  the  speculative  and  accidental  possibilities. 
If  a  business  enterprise  purchases  raw  materials  in  a  falling 
market  and  sells  the  finished  product  in  a  rising  market  actual 
appreciation  is  involved  in  the  revenue  from  operation.  This 
can  be  made  clear  by  an  illustration.  Suppose  that  a  whole- 
saler buys  merchandise  for  $100,000,  and  that  before  he  sells 
again  an  advance  in  price  occurs  which  would  mean  a  price  of 
$120,000  for  this  same  lot  if  he  were  buying  now.  The  merchant 
will  now  be  able  to  sell  this  lot  for  $120,000  plus  his  customary 

1  In  general  accountants  object  to  the  recognition  in  the  accounts  of  the  appre- 
ciation of  unsold  assets,  although  the  validity  of  depreciation  as  a  matter  of  account- 
ing record  is  admitted.  This  opinion  is  due  in  part  to  conservatism,  and  in  part 
to  a  misunderstanding  of  the  functions  of  accounting  and  the  implications  involved 
?n  valuations.  In  Chapter  XX  the  general  principles  of  valuation  will  be  fully 
discussed. 


DETERMINATION  OF  NET  REVENUE       241 

advance,  or,  in  other  words,  gross  revenue  is  increased  by  $20,000 
due  to  appreciation.  The  amount  of  net  revenue  in  such  a  case 
is  not  restricted  simply  to  the  results  of  operation  in  the  narrow 
sense.  Similarly,  costs  may  be  unusually  heavy  in  a  particular 
period  due  to  accidents  and  unfavorable  price  changes.  If 
such  costs  are  treated  as  current  expense  —  as  is  usually  done  — 
the  net  revenue  figure  will  not  indicate  merely  the  results  for 
which  the  manager  and  the  other  operating  officials  are  directly 
responsible. 

An  ideal  classification  of  expense  and  revenue  accounts  would 
undoubtedly  be  based  on  the  principle  that  all  charges  and 
credits  applicable  to  technical  operation  as  such  should  be 
segregated  in  the  "operating"  accounts,  and  that  all  accruals 
due  to  speculative  changes  and  ancillary  operations  should  be 
shown  in  the  " non-operating"  accounts.  This  goal  is  far  from 
realized  in  any  system  of  accounts  now  in  use,  however ;  and  in 
view  of  the  complexities  of  the  typical  industrial  situation  it  is 
doubtful  if  this  ideal  can  ever  be  more  than  approximated.  In- 
deed the  notion  of  operation  as  a  mere  mechanical  process  can 
hardly  be  said  to  be  justified  as  an  accounting  conception. 
Production  is  an  economic  process,  and  the  speculative  exigencies 
of  business  life  are  inextricably  bound  up  with  physical  produc- 
tion. In  some  cases  production  consists  entirely  in  the  per- 
formance of  services ;  and  often  it  might  be  said  that  the  taking 
of  risk  is  an  important  part  'of  the  regular  productive  function. 
In  such  cases,  certainly,  it  would  seem  reasonable  to  consider 
all  value  accruals  as  applicable  to  the  regular  expense  and  revenue 
accounts. 

Emphasis  has  been  laid  in  a  preceding  section  upon  the  im- 
portance of  preserving  in  the  accounts  and  statements  the 
integrity  of  the  accounting  period.  In  an  important  sense  it 
might  be  said  to  be  the  function  of  accounting  to  present  a 
classification  of  business  transactions  and  accruals  in  terms  of 
fiscal  periods.  In  this  connection  the  appreciation  of  assets  — 
particularly  current  assets  such  as  materials  —  has  an  important 
bearing.  This  can  best  be  shown  by  means  of  an  illustration. 
A  retail  merchant,  it  will  be  assumed,  buys  goods  in  October, 
1917,  amounting  to  $25,000.  The  journal  entries  at  the  time 
of  purchase  would  be : 


242  PRINCIPLES  OF  ACCOUNTING 

Merchandise $25,000 

Cash $25,000 

On  December  3ist  the  merchant  closes  his  books  and  prepares 
statements.  At  that  time  the  lot  of  merchandise  purchased  in 
October  is  still  unsold,  and  it  is  discovered  that  it  would  now 
cost  $30,000  to  replace  this  shipment.  On  the  theory,  however, 
that  no  revenue  is  yet  realized,  the  appreciation  of  merchandise 
is  not  recognized  in  the  accounts.  During  January,  1918,  these 
goods  are  sold  for  $40,000,  an  advance  of  $5,000  over  the  price 
which  would  have  been  realized  had  there  been  no  increase  in 
wholesale  prices.  The  entries  —  assuming  cash  sales  —  would 
now  be  as  follows : 

Cash $40,000 

Sales $40,000 

These  entries  show  that  a  gross  revenue  of  $40,000  is  realized 
in  1918. 

But  do  these  entries  show  the  actual  situation?  Is  the  1918 
management  entirely  responsible  for  this  revenue?  Or  is  it 
not  true  that  a  part  of  this  revenue  —  $5,000  —  accrued  in  1917 
and  should  be  credited  to  the  revenue  accounts  for  that  year? 
At  least  there  would  seem  to  be  some  force  to  this  contention. 
Had  the  appreciation  of  merchandise  been  recognized  when 
the  accounts  were  closed  in  1917  the  entries  might  have  been 
as  follows : 

Merchandise $5,ooo 

Revenue  from  Appreciation  ....  $5,000 

These  entries  would  have  served  to  allocate  to  the  revenue 
accounts  for  1917  the  revenue  actually  realized  in  that  year  — 
realized  in  the  form  of  added  value  in  merchandise.     The  charge 
to  Merchandise  would  serve  to  increase  the  cost  of  goods  sold 
in  1918  by  $5,000,  and  hence  would  reduce  the  showing  of  revenue 
for  that  year  —  as  far  as  this  shipment  of  goods  is  concerned  - 
by  that  amount. 

This  procedure  should  not  be  confused  with  the  illegitimate 
practice  of  forecasting  profits  in  the  accounts.  To  forecast 
profit  is  to  use  selling  prices  in  taking  inventories.  To  accrue 
the  revenue  due  to  an  increase  in  the  cost  of  replacing  materials 


DETERMINATION  OF  NET  REVENUE       243 

and  similar  assets  is  an  entirely  different  matter.  Whatever 
may  be  decided  about  the  wisdom  of  recognizing  appreciation 
in  the  accounts,  it  at  least  should  be  admitted  that  this  is  not 
the  same  thing  as  the  anticipation  of  profit. 

A  word  should  be  added  in  this  connection  concerning  the 
wisdom  or  possibility  of  declaring  dividends  on  the  strength  of 
a  showing  of  net  revenue  which  is  due  in  part  to  appreciation 
of  unsold  assets.  In  general  it  may  be  said  that  dividends 
are  based  upon  the  net  revenue  figure  rather  than  upon  the  cash 
balance,  and  that  in  any  case  net  revenue  is  likely  to  be  repre- 
sented on  the  asset  side  by  general  assets  rather  than  by  cash 
alone.  The  current  assets  received  when  goods  are  sold  may  be 
shortly  invested  in  additional  material,  supplies,  machines,  etc. 
In  general  appreciated  assets  form  as  solid  a  basis  for  credit  and 
dividends  as  additional  units.  On  the  other  hand  it  should  be 
noted  that  even  in  the  case  of  a  net  revenue  figure  based  entirely 
upon  sales  the  condition  of  the  money  market  and  other  factors 
may  make  it  unwise  to  declare  dividends. 

In  this  section  it  is  intended  merely  to  suggest  the  way  in 
which  asset  valuations  affect  the  net  change  in  the  status  of 
the  equities  during  a  given  period.  The  problems  of  valuation 
have  many  other  accounting  implications.  In  Part  IV  par- 
ticular attention  is  given  to  these  problems.  The  significance 
and  treatment  of  appreciation  will  be  more  fully  discussed  in 
this  connection. 


PART  TWO 
THE  EQUITY  ACCOUNTS 


XI 

PROPRIETORSHIP  —  SINGLE -PROPRIETORS'  AND  PARTNERS' 
ACCOUNTS 

THE  point  has  been  emphasized  repeatedly  in  the  foregoing 
pages  that  the  accounts  of  a  business  enterprise  are  kept  pri- 
marily from  the  standpoint  of  the  private  equities  involved.  It 
is  the  private  owners  —  the  interests  that  furnish  the  necessary 
capital  —  who  have  control  of  business  operation  in  any  case. 
The  net  revenue  figure  —  the  goal  of  the  business  struggle  from 
the  accounting  standpoint  —  measures  the  change  in  the  status 
of  these  equities.  Hence  the  accounts  which  represent  the  equi- 
ties form  in  many  ways  the  most  important  group  of  accounts. 
The  results  of  the  business  process  are  reflected  particularly  in 
these  accounts ;  the  financial  history  of  the  enterprise  can  be 
read,  in  large  measure,  from  these  accounts.  Several  chapters 
will  now  be  devoted  to  a  discussion  of  the  nature  of  the  principal 
types  of  equities,  and  to  an  analysis  of  the  typical  transactions 
affecting  the  accounts  with  these  interests.  As  already  noted 
the  laborer  has  a  current  equity  in  the  business  enterprise,  but 
this  equity  is  retired  so  frequently  as  seldom  to  assume  impor- 
tant accounting  significance.  Similarly  the  state  through  its  tax 
power  may  be  said  to  have  an  equity  in  every  enterprise ;  but 
the  state's  claim  is  also  an  equity  which  is  currently  retired.  It 
is  the  equity  accounts  which  represent  the  capital  investment  in 
any  case  which  are  of  particular  accounting  importance  ;  and  in 
the  following  chapters  it  is  these  accounts  which  will  receive 
especial  attention.  The  present  chapter  begins  a  discussion  of 
the  most  important  equity  from  the  accounting  standpoint,  the 
proprietorship  interest,  and  is  devoted  primarily  to  an  analysis 
of  the  proprietary  accounts  in  single-proprietorships  and  partner- 
ships. 

PROPRIETORSHIP 

The  ownership  of  property,  broadly  understood,  is  a  complex 
fact  comprising  several  elements.  The  principal  burdens  as- 

247 


248  PRINCIPLES  OF  ACCOUNTING 

sumed  by  the  investor  in  a  business  enterprise  are:  (i)  the 
bearing  of  risk ;  (2)  the  taking  of  responsibility  and  control ; 
(3)  the  furnishing  of  capital-service.  (Sometimes  the  proprie- 
tor furnishes  ordinary  labor  services  as  well.)  These  phases  of 
ownership  are  more  or  less  inseparable :  for  example,  there  can 
be  no  risk  without  the  furnishing  of  capital ;  nevertheless  these 
different  elements  may  be  subdivided  and  combined  in  a  great 
variety  of  ways,  as  is  evidenced  by  the  specialization  of  securities 
in  the  modern  business  organization.  The  division  of  all  equities 
into  proprietorship  and  liabilities  is  based  upon  an  important 
general  classification  of  the  burdens  —  and  accompanying  priv- 
ileges —  of  ownership  just  mentioned. 

The  line  drawn  in  accounting  between  proprietorship  and  out- 
side equities  or  liabilities  corresponds  roughly  to  the  distinction 
made  in  economics  between  the  entrepreneur  and  the  capitalist 
proper.  The  individual  or  interest  that  assumes  the  major  ele- 
ment of  risk  in  a  business  enterprise  and  takes  the  major  share  of 
final  responsibility  and  control  is  the  entrepreneur ;  the  indi- 
vidual or  interest  that  furnishes  capital,  but  takes  comparatively 
little  risk  and  has  but  slight  control  of  financial  policies  and  busi- 
ness operation  is  the  capitalist  proper.1  Similarly  the  equities 
which  involve  the  large  element  of  risk  and  control  of  operation 
form  proprietorship ;  the  other  equities  which  carry  less  risk 
and  less  control  are  the  outside  equities  or  liabilities  proper. 

This  general  distinction  may  be  expressed  more  concretely. 
All  equities  which  have  contractual  rights  to  assets  as  either  in- 
come or  principal  are  liabilities ;  the  equities  which  have  residual 
rights  to  assets  constitute  proprietorship.  In  other  words  the 
proprietor's  equity  acts  as  a  buffer  for  all  other  equities  in  the 
enterprise.  All  contractual  accruals  of  income  must  be  met 
before  any  proprietary  income  is  available;  all  contractual 
rights  in  capital  must  be  met  in  case  of  financial  disaster,  or 
liquidation  for  any  reason,  before  the  proprietor's  claim  may  be 
considered.  On  the  other  hand  whatever  sum  is  available 
either  as  income  or  principal  after  other  claims  are  satisfied  is 
proprietorship.  The  proprietor  assumes  in  large  measure  the 
burden  of  speculative  losses;  the  proprietor  realizes  in  large 
measure  the  benefit  of  speculative  gains. 

1  Cf .  Taylor,  Principles  of  Economics, 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      249 

On  the  accounting  side  the  proprietary  equity  is  of  particular 
importance  because  the  proprietor  is  in  control.  The  proprietor 
—  albeit  there  are  certain  important  reservations  in  particular 
cases  —  has  almost  complete  ultimate  control  of  business  opera- 
tion and  financial  policies.  The  proprietor  —  or  his  manager 
-buys  materials,  hires  laborers,  decides  as  to  processes,  finds 
a  market,  extends  credits,  etc.  Naturally  the  proprietor's  in- 
terest tends  to  dominate  accounting  theories,  methods  and  poli- 
cies. This  point  of  view,  however,  has  been  unduly  stressed  in 
the  case  of  corporation  accounting.  The  present  tendency  in 
corporation  finance  is  toward  the  restriction  of  proprietary  con- 
trol in  favor  of  the  other  important  equities.1 

The  legal  view  which  practically  identifies  the  business  organi- 
zation with  the  proprietor's  equity  in  many  cases  gives  added 
accounting  importance  to  proprietorship.  A  study  of  reorgani- 
zations in  the  case  of  large  corporations,  however,  reveals  the 
fact  that  the  courts  are  now  thinking  of  the  business  enterprise 
as  a  unit  with  a  variety  of  equities,  each  of  which  has  certain 
peculiar  rights  and  privileges.  It  should  also  be  observed  that 
the  legal  view  is  not  necessarily  the  proper  standpoint  for  the 
accountant.  The  legal  liability  in  the  case  of  a  promissory  note, 
for  example,  is  always  the  par  or  face  of  the  note.  The  account- 
ing liability  at  the  outset  is  the  amount  actually  realized.  As 
the  note  matures  it  "accrues"  to  par. 

There  are  other  important  general  distinctions  between  pro- 
prietorship and  liabilities.  The  proprietary  equity  is  normally 
perpetual  —  or  at  least  indefinite  in  length.  A  liability  is  gen- 
erally terminable.  Further,  a  firm  does  not  become  bankrupt 
if  proprietary  claims  are  not  met ;  but  if  interest  or  principal  is 
defaulted  in  the  case  of  a  typical  liability  legal  insolvency  is 
likely  to  ensue.  These  distinctions  will  be  further  considered  in 
the  following  chapter. 

In  accounting  practice  proprietorship  and  the  accounts  rep- 
resenting this  equity  are  quite  definitely  defined.  In  the  pre- 

1  All  general  distinctions  between  proprietorship  and  liabilities  must  be  stated 
with  decided  qualifications  when  applied  to  the  most  important  type  of  business 
organization,  the  corporation.  The  difference  between  the  proprietary  equity  and 
the  liabilities  is  an  important  one  but  no  hard  and  fast  distinctions  can  be  stated 
which  apply  in  all  cases.  Corporate  proprietorship  will  be  discussed  in  the  next 
chapter. 


250  PRINCIPLES  OF  ACCOUNTING 

reding  chapters  the  important  proprietary  accounts  have  been 
frequently  mentioned  and  briefly  explained.  It  will  now  be 
necessary,  however,  to  discuss  more  elaborately  these  accounts 
and  the  important  types  of  transactions  involved,  especially 
from  the  standpoint  of  the  leading  types  of  business  organiza- 
tion:  (i)  the  single-proprietor  enterprise;  (2)  the  partnership; 
(3)  the  corporation.  The  difference  between  the  accounting 
for  one  type  of  organization  as  compared  with  another  lies  pri- 
marily in  the  distinction  between  the  equities  and  the  equity 
accounts  involved.  The  details  of  the  various  legal  phases  of 
the  different  types  of  organization  will  be  introduced  only  when 
necessary  for  the  explanation  of  the  accounts  and  the  trans- 
actions. 

THE    SINGLE-PROPRIETOR   ENTERPRISE 

The  simplest  form  of  proprietorship  is  found  in  the  case  where 
this  equity  is  vested  in  a  single  person.  Anyone  who  is  produc- 
ing for  sale  a  commodity  or  service  requiring  for  its  production 
the  outlay  of  capital  might  be  called  a  proprietor.1  If  the  person 
directing  production,  however,  owns  no  capital  in  the  enterprise, 
he  is  simply  a  manager  or  laborer  selling  his  personal  service. 

It  is  in  this  form  of  organization  that  the  distinction  between 
proprietorship  and  liabilities  can  be  most  clearly  drawn.  The 
proprietor  in  such  a  case  is  usually  spoken  of  as  the  "owner." 
The  liabilities  are  said  to  represent  the  amount  due  to  the  "credi- 
tors" of  the  business.  The  "net  worth"  of  the  enterprise  con- 
stitutes the  proprietor's  equity.  The  liabilities  show  the  amount 
that  he  owes.  The  proprietor  usually  has  almost  entire  control ; 
and  his  equity  is  likely  to  represent  from  seventy-five  to  ninety- 
five  per  cent  of  the  total  investment.  In  all  such  cases  it  is  easy 
to  identify  the  proprietor  with  the  enterprise  itself,  and  to  con- 
ceive of  proprietorship  as  representing  the  actual  ownership. 
This  is  a  more  narrow  conception  of  ownership  than  the  one  given 
in  the  preceding  section,  however,  and  it  is  not  an  entirely  satis- 
factory view  even  in  the  case  of  a  single-proprietorship.  For 

1  As  was  previously  explained  the  business  enterprise  is  conceived  in  this  text 
as  an  establishment  producing  something  for  sale.  Obviously  accounting  problems 
arise  in  connection  with  the  ownership  of  consumption  goods ;  and  the  owner  of  such 
goods  might  reasonably  be  considered  a  proprietor. 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      251 

example,  can  it  be  legitimately  said  that  a  person  owns  outright 
mortgaged  property?  Is  it  not  rather  true  that  the  proprietor 
in  such  a  case  shares  with  another  the  privileges  and  burdens  of 
ownership?  Certainly  there  are  many  cases  in  which  the  pro- 
prietor so-called  is  trading  on  a  " shoestring."  The  proprietor 
in  such  a  case  is  little  more  than  the  manager  for  the  real  owners. 
If  absolute  control  is  vested  with  such  a  proprietor  the  interests 
of  the  actual  owners  are  jeopardized.  The  restriction  of  ultimate 
control  to  those  who  furnish  at  least  a  significant  part  of  the  capi- 
tal is  a  healthy  tendency  in  corporation  finance.  Even  in  the 
case  of  the  single-proprietor  business  the  view  which  looks  upon 
all  the  equities  as  representing  aspects  of  ownership  is  the  more 
significant  conception  for  the  accountant  to  adopt. 

If  a  business  enterprise  be  defined  in  the  broad  sense  suggested 
above  it  must  be  admitted  that  there  are  more  single-proprietor- 
ships than  of  all  other  types  of  organization  combined.  But  this 
does  not  mean  that  this  type  of  enterprise  is  the  most  important 
for  the  accountant.1  The  newsboy  on  the  street  corner  might 
be  thought  of  as  a  proprietor ;  but  his  business  is  so  small  that 
he  has  little  need  for  records  of  any  kind  as  all  the  details  of  his 
business,  financial  and  otherwise,  can  be  readily  kept  in  mind. 
The  great  majority  of  typical  single-proprietorships,  however, 
are  of  sufficient  consequence  to  require  accounting  records. 

In  practice  many  such  enterprises  do  not  use  the  complete 
double-entry  method.  Quite  commonly  a  small  concern  will 
keep  a  set  of  books  which  contain  accounts  with  properties  and 
liabilities,  but  which  omit  the  proprietary  accounts.  There  are 
few  firms,  however,  which  require  accounts  of  any  kind  that  might 
not  advantageously  make  use  of  the  complete  double-entry 
system.  In  most  cases  this  system  will  prove  far  simpler  in 
the  long  run  than  any  possible  abbreviation. 

A  concrete  illustration  will  serve  as  a  convenient  basis  for  the 
discussion  of  the  proprietary  accounts  and  the  transactions 
affecting  such  accounts  in  the  case  of  a  business  where  proprie- 
torship resides  in  a  single  individual.  It  will  be  assumed  that  A 

1  In  point  of  aggregate  capital  controlled,  number  of  employees,  units  of  output, 
financial  influence,  etc.,  the  corporation  leads  in  many  important  lines  of  industry. 
In  the  case  of  the  corporation  the  importance  of  proper  accounting  for  the  equities 
is  greatly  magnified. 


252 


PRINCIPLES  OF  ACCOUNTING 


is  a  small  manufacturer ;  and  that  the  following  statement  rep- 
resents the  financial  status  of  his  business  on  July  ist,  1918  : 


ASSETS 

Real  Estate $  7,500 

Machinery      .     t    .     .     .  8,700 

Tools  and  Supplies       .     .  5,600 

Finished  Product     .     .     .  5,ooo 

Materials 11,900 

Cash 6,100 

Accounts  Receivable    .     .  4,200 

Coal 500 

Insurance  Prepaid   .     .     .  700 


EQUITIES 

A,  Capital       .    .    .    . 

Mortgage 

Notes  Payable     .     .     . 
Accounts  Payable    .     . 


$33,000 
8,500 
2,300 
6,400 


The  account  entitled  A,  Capital  represents  proprietorship  in 
this  statement.  Other  terms  might  be  used  for  the  main  proprie- 
tary account  such  as  A,  Proprietor  or,  simply,  Proprietor.  The 
name  of  the  proprietor  without  any  accompanying  explanatory 
phrase  is  frequently  employed  to  designate  this  account. 

The  expense  and  revenue  statement  at  the  end  of  the  month  of 
July,  it  will  be  assumed,  is  as  follows  (in  account  form) : 


EXPENSE 

Labor $1,200 

Depreciation  Expense  .  . 
Materials  Consumed  .  . 
Fuel  Expense  .... 
Insurance  Expired  .  .  . 
Uncollectible  Accounts  . 
Miscellaneous  .... 
Decrease  in  Inventories  . 

Net  Revenue 


REVENUE 
Sales $6,600 


150 
,5oo 
300 
100 

5° 
200 

SOP 


,000 
600 


$6,600 


$6,600 


The  following  represents  the  net  revenue  statement  at  this 
time: 

NET  REVENUE 


Interest      

Proprietary  Net  Income 


$100 

500 

$600 


From  Expense  and  Revenue      $600 


$600 


SINGLE-PROPRIETORS'  AND  PARTNERS'  ACCOUNTS     253 

The  balance  of  this  statement,  $500,  constitutes  the  increase 
in  proprietorship,  or  the  increase  in  A's  equity.  The  journal 
entries  (assuming  a  Net  Revenue  account  is  used)  which  trans- 
fer this  item  to  A,  Capital  would  be : 

Net  Revenue $500 

A,  Capital $500 

If  now  A  decided  to  withdraw  this  profit  the  entries  would  be  as 
follows : 

A,  Capital $500 

Cash $500 

The  first  pair  of  entries  simply  transfer  the  item  of  proprietary 
net  income  from  an  allocation  account  to  the  proprietor's  regular 
account  and  therefore  merely  represent  a  transposition  of  equi- 
ties. The  second  pair  of  entries  recognize  the  withdrawal  of 
cash  and  an  equal  decline  in  proprietorship  as  stated. 

Frequently  such  an  account  as  A,  Capital  is  used  to  show  only 
the  permanent  investment  that  it  is  expected  will  be  left  in  the 
business.  This  account  in  such  a  case  is  credited  with  the 
amount  of  all  investments  and  is  charged  with  all  retirements  of 
original  capital.  Another  account  is  then  introduced  called  (for 
example)  A,  Drawing,  which  is  credited  with  all  items  of  income 
and  debited  with  all  withdrawals  of  income  from  the  business. 

In  accounting  practice  an  allocation  account  such  as  Net 
Revenue  is  seldom  used  in  the  case  of  a  single-proprietorship. 
Items  of  interest  and  proprietary  income,  together  with  all  ex- 
penses, are  charged  to  a  summary  account,  Profit  and  Loss.  In 
the  case  of  a  simple  business  this  procedure  may  be  considered 
expedient,  but  such  confusion  of  unlike  classes,  as  was  emphasized 
in  a  preceding  chapter,  should  be  avoided  as  a  rule.  There  are 
few  cases  in  which  a  clear-cut  division  in  the  accounts  of  gross 
and  net  revenue  charges  and  credits  is  not  advisable. 

In  the  case  of  actual  losses  and  extraordinary  gains  entries 
might  be  made  directly  in  the  main  proprietary  accounts  to  re- 
flect such  happenings.  Suppose,  for  example,  that  a  storm  dam- 
ages A's  building  (referring  to  above  illustration)  to  the  extent 
of  $1,500.  This  occurrence  would  be  journalized  as  follows  : 

A,  Capital .- $1,500 

Real  Estate $1,500 


254  PRINCIPLES  OF  ACCOUNTING 

Similarly  an  extraordinary  gain  would  require  a  credit  to  A, 
Capital.  A  customer's  account  amounting  to  $500,  for  example, 
which  has  been  considered  worthless  and  has  been  written  from 
the  books,  is  paid  in  full.  The  entries  would  be : 

Cash $500 

A,  Capital $500 

In  case  the  proprietor  allows  himself  a  salary  as  an  expense 
(see  page  224)  in  order  that  net  income  may  be  restricted  to  a 
return  to  capital  as  such,  but  does  not  withdraw  the  sum  allowed, 
it  is  necessary  to  credit  a  proprietary  account  for  the  amount  of 
the  expense  charge.  Suppose  A,  for  example,  allows  a  salary 
of  $150  per  month  for  his  own  services,  but  makes  no  immediate 
withdrawal  of  this  amount.  The  entries  would  be : 

A's  Salary $150 

A,  Drawing $150 

If  A  decides  to  leave  this  amount  in  the  business  permanently 
as  investment  the  item  may  be  transferred  to  A,  Capital,  thus : 

A,  Drawing •  ...     $150 

A,  Capital $150 

These  entries  have  exactly  the  same  final  effect  upon  the  accounts 
as  would  be  the  case  if  A  withdrew  the  amount  of  his  salary  in 
cash  and  immediately  reinvested  the  same  amount.  The  entries 
in  this  event  would  be : 

d) 

A's  Salary $150 

Cash $150 

and, 

(a) 

Cash $150 

A,  Capital $150 

This  discussion  shows  the  simplicity  of  the  proprietary  accounts 
and  the  transactions  affecting  these  accounts  in  the  case  of  a 
single-proprietor  enterprise.  The  need  for  keeping  accounts 
with  proprietorship  in  such  cases  is  not  as  great  as  in  enterprises 
having  a  more  complex  form  of  organization.  If  accounts  are 
kept  with  all  asset  items  and  with  all  liabilities,  proprietorship 
-  the  difference  between  assets  and  liabilities  —  can  be  readily 


t 

SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      255 

ascertained  from  these  accounts  provided  the  other  items  are 
correctly  exhibited.  This  is  an  indirect  method,  but  might  be 
feasible  in  the  case  of  a  very  simple  business.  In  such  a  case, 
however,  the  advantage  of  the  complete  double-entry  method 
in  furnishing  a  test  for  numerical  accuracy  would  be  lost.  Fur- 
ther, unless  subsidiary  equity  accounts  (or  at  least  a  general 
expense  and  revenue  account)  were  kept,  there  would  be  little 
information  in  the  records  concerning  the  process  whereby  the 
changes  in  the  proprietor's  equity  had  been  brought  about. 
The  various  "single-entry"  and  incomplete  systems  in  use  by 
so  many  firms  are  not  to  be  commended. 

COPARTNERSHIP   PROPRIETARY  ACCOUNTS 

A  partnership,  or  copartnership,  is  an  association  by  contract 
of  two  or  more  persons 'who  have  combined  their  capital  and  skill 
in  a  business  venture  for  the  purpose  of  joint  profit.  The  part- 
nership agreement  or  contract  may  be  either  written  or  oral  — 
aside  from  special  statutes  to  the  contrary ;  but  as  a  matter  of 
business  expediency  carefully  constructed  articles  of  copartner- 
ship should  always  be  prepared  which  state  in  detail  the  relations 
of  the  partners  in  regard  to  investments,  division  of  income, 
participation  in  management,  drawings,  rights  at  dissolution,  etc. 
It  is  even  desirable  to  have  the  contract  go  so  far  as  to  specify 
the  accounting  methods  which  shall  be  used ;  and  detail  direc- 
tions relating  to  methods  of  production  and  other  questions  of 
management  may  well  be  stated  in  writing.  At  least  authority 
to  settle  such  matters  should  be  specifically  delegated ;  other- 
wise there  are  certain  to  be  endless  disputes  and  consequent  in- 
efficiency. The  accountant's  work  in  connection  with  partner- 
ships is  very  much  simplified  if  the  articles  of  agreement  give 
definite  instructions  concerning  the  important  contingencies 
which  may  arise.  A  carefully  stated  contract  minimizes  the 
possibility  of  legal  disputes  and  obviates,  in  large  measure,  the 
need  for  special  audits. 

Certain  general  peculiarities  of  the  firm  '  or  partnership  should 

1  The  term  firm  is  usually  restricted  in  law  to  the  partnership.  An  established 
single-proprietorship  making  use  of  a  firm  name,  however,  may  also  be  called  a  firm 
or  "house"  with  propriety. 


256  PRINCIPLES  OF  ACCOUNTING 

be  mentioned.  The  ordinary  partnership,  unless  formed  for  a 
specified  time,  is  a  partnership  "at  will,"  and  may  be  dissolved 
at  any  time  by  any  partner.  That  is,  a  partner  may  usually 
withdraw  at  any  time  even  against  the  wishes  of  his  associates, 
and  by  such  a  withdrawal  the  firm  is  thereby  dissolved.  This  is 
an  important  general  characteristic  of  the  partnership  as  com- 
pared with  the  corporation.  Further,  every  member  of  an  or- 
dinary partnership  is  liable  to  the  entire  amount  of  his  private 
estate  for  the  debts  and  engagements  of  the  firm.  In  other  words 
a  partner  risks  not  only  the  loss  of  his  entire  investment  in  the 
firm  but  the  loss  of  any  other  property  he  may  own  should  the 
partnership  become  insolvent  (and  its  liabilities  exceed  its  assets). 
This  fact  of  "unlimited  liability"  accounts  in  some  measure  for 
the  inadequacy  of  the  partnership  form  to  meet  the  needs  of  large 
scale  production.  Where  a  large  aggregate  of  capital  is  needed 
it  would  usually  be  very  difficult  to  induce  a  sufficient  number 
of  investors  to  combine  their  interests  on  this  basis. 

There  may,  of  course,  be  any  number  of  partners,  although 
in  actual  business  there  are  very  few  partnerships  with  more 
than  four  or  five  members.  The  several  partners  may  be  asso- 
ciated on  an  equality  as  regards  investments,  management,  draw- 
ings, etc. ;  but  very  commonly  there  are  differences  in  the  rights 
of  the  partners  in  one  or  more  of  these  respects.  The  law  rec- 
ognizes several  kinds  of  partners  with  which  the  accountant 
should  be  familiar.  A  "silent"  or  dormant  partner  is  one  who 
takes  little  if  any  active  part  in  the  transaction  or  control  of  the 
partnership  business.  A  "secret"  partner  is  one  who  is  not 
known  as  a  partner,  although  he  may  be  active  in  the  manage- 
ment of  the  affairs  of  the  firm.  A  "nominal"  partner  is  not  a 
partner  by  contract  or  agreement,  but  may  be  considered  a  part- 
ner legally  if  he  has  knowingly  permitted  himself  to  be  "held 
out"  as  a  partner  to  the  public. 

The  "limited"  partnership  and  the  joint  stock  association 
are  special  types  of  partnerships.  Limited  partnerships  are 
authorized  by  statutes  in  most  of  our  states.  In  such  firms 
the  liability  of  certain  members  called  "special"  partners  is 
limited  to  the  amount  of  capital  contributed  in  any  case.  Other 
members,  called  "general  "  partners,  are  liable  to  the  creditors 
—  or  outside  equities  —  for  all  the  obligations  of  the  firm  as  in 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      257 

the  ordinary  partnership.  The  joint  stock  association  is  usually 
nothing  more  than  a  large  partnership  having  transferable  shares 
which  represent  the  partners'  equities.  The  unlimited  liability 
feature  pertains  to  such  companies  as  in  the  case  of  regular  part- 
nerships. In  this  country  the  joint  stock  company  is  not  at 
present  a  popular  form  of  organization,  and  has  almost  entirely 
given  way  to  the  corporation. 

In  a  partnership  the  equities  of  the  partners  constitute  proprie- 
torship. The  partners'  accounts  are  the  proprietary  accounts. 
All  other  equities  represent  the  liabilities  of  the  firm.  In  the 
absence  of  special  agreement  to  the  contrary  the  assets  of  the 
partnership  are  joint  property.  No  specific  asset  belongs  ex- 
clusively to  any  partner.  A  partner's  interest  is  simply  a  right 
to  share  in  the  general  assets  of  the  firm  after  all  liabilities  have 
been  met. 

Although  the  law  makes  a  rather  sharp  distinction  between 
the  equities  of  the  partners  and  the  liabilities  or  debts  of  the  firm 
it  is  important  that  the  accountant  keep  in  mind  a  conception 
of  the  firm  as  an  entity.  The  balance  sheet  of  a  partnership  is 
prepared  in  the  same  way  as  the  balance  sheet  of  a  corporation 
—  all  assets  on  one  side,  all  equities  on  the  other.  The  balance 
sheet  is  the  groundwork  of  partnership  accounting  as  it  is  of 
single-proprietorship  or  corporation  accounting.  Hence  the 
various  transactions  occurring  should  be  viewed  from  the  stand- 
point of  the  enterprise  as  a  whole  rather  than  in  terms  of  the  part- 
ners' equities  alone.  An  individual  partner,  for  example,  may 
borrow  from  or  loan  to  the  firm  in  much  the  same  manner  as  an 
outsider.  This  is  one  illustration  of  the  type  of  situation  arising 
which  requires  the  accountant  to  think  of  the  entire  enterprise 
as  a  unit. 

In  the  partnership  the  proprietary  accounts  are  more  numerous 
than  in  a  single-proprietor  enterprise,  and  some  complexities 
arise.  For  an  illustration  it  will  be  assumed  that  in  the  balance 
sheet  shown  in  the  preceding  section  proprietorship  is  repre- 
sented by  the  capital  accounts  of  two  equal  partners,  A  and  B, 
instead  of  the  single  proprietary  account.  The  expense  and 
revenue  statement  at  the  end  of  one  month  will  be  assumed  to 
be  the  same  as  for  the  single-proprietorship.  Hence,  as  far  as 
expense  and  revenue  and  other  subsidiary  equity  accounts  are 


258  PRINCIPLES  OF  ACCOUNTING 

concerned,  there  would  be  exactly  the  same  records  required  for 
the  partnership  as  in  the  simpler  organization.  The  entries 
closing  the  item  of  net  income  into  the  proprietary  accounts 
would  differ  only  in  that  more  accounts  would  be  involved,  thus  : 

Net  Revenue $500 

A,  Capital $250 

B,  Capital 250 

In  distributing  profits  or  making  other  withdrawals  the  part- 
ner's capital  account  is  debited  and  Cash  is  credited  as  in  the 
case  of  the  single-proprietorship.  The  other  types  of  proprie- 
tary transactions  illustrated  in  the  preceding  section  would  be 
handled  in  the  same  manner  on  the  books  of  the  equal  partner- 
ship except  that  two  proprietors  would  be  involved  instead  of 
one. 

There  is  likely  to  be  little  regularity  about  the  distribution  of 
income,  or  withdrawals  of  investment,  by  the  partners  unless 
there  is  specific  stipulation  in  regard  to  this  point  in  the  articles 
of  agreement.  This  is  one  reason  why  the  capital  accounts  of 
partners  frequently  show  such  disproportionate  balances.  Usually 
the  investments  at  the  outset  are  equal  or  represent  simple  frac- 
tions of  total  proprietorship,  but  the  irregularity  of  withdrawals 
may  soon  disturb  this  relation.  Such  a  situation  often  makes 
the  computation  of  a  partner's  share  in  income,  or  in  assets  at 
dissolution,  somewhat  cumbersome.  Drawing  or  "personal" 
accounts  are  especially  useful  in  the  case  of  a  partnership  to  show 
current  increases  and  decreases  in  the  partners'  equities. 

When  income  is  not  divided  among  the  partners  in  proportion 
to  investments,  interest  may  be  allowed  on  each  partner's  equity, 
and  then  a  distribution  of  the  residual  income  made.  A  varia- 
tion of  the  above  case  will  serve  as  an  illustration.  Suppose  that 
of  the  partners  mentioned  A  is  the  only  one  actively  interested 
in  the  business,  while  B  is  a  silent  partner,  investing  capital  and 
assuming  risk  but  taking  only  slight  interest  in  actual  manage- 
ment. The  articles  of  copartnership,  it  may  be  assumed,  stipu- 
late that  after  each  partner  is  allowed  six  per  cent  on  his  invest- 
ment the  balance  of  the  income  is  to  be  divided,  two-thirds  to  A 
and  one-third  to  B.  In  this  case  the  situation  may  be  shown  on 
the  books  by  making  two  distinct  distributions  of  income  among 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      259 

the  partners.  The  entries  (using  drawing  accounts)  would  be 
somewhat  as  follows  c 

(i) 
Net  Revenue $165 

A,  Drawing $82.50 

B,  Drawing 82.50 

which  credits  each  partner  with  one  month's  interest  on  $16,500 
at  six  per  cent ;  and, 

(2) 
Net  Revenue $335 

A,  Drawing $223.33 

B,  Drawing 111.67 

which  distributes  the  balance  of  net  income,  two-thirds  to  A  and 
one- third  to  B. 

In  computing  total  proprietorship  in  the  case  of  a  partnership 
any  credit  balances  in  the  drawing  accounts  must  be  added  to 
investment  as  shown  by  the  capital  accounts.  For  even  if  such 
accounts  show  equity  balances  that  are  to  be  withdrawn,  as  long 
as  such  items  remain  in  the  business  they  form  a  part  of  total 
proprietorship.  The  equity  of  an  individual  partner  would  be 
similarly  determined.  In  winding  up  the  affairs  of  a  partnership, 
however,  the  drawing  account  balances  would  not  always  be 
settled  on  the  same  basis  as  the  capital  account  balances.  The 
articles  of  agreement  may  require,  for  example,  a  division  of  the 
assets  between  partners  in  proportion  to  original  investments. 
If  such  an  agreement  obtains  provision  should  also  be  made  to 
insure  the  maintenance  of  each  partner's  equity,  at  least  approxi- 
mately. Otherwise  serious  disputes  concerning  the  distribution 
of  assets  at  time  of  dissolution  are  likely  to  arise. 

The  need  for  an  adequate  system  of  proprietary  and  subsidiary 
accounts  in  the  case  of  the  partnership  is  evidently  imperative. 
The  amount  of  each  partner's  original  investment  may  appear 
in  the  articles,  but  these  amounts  soon  become  obscured  by 
withdrawals  and  accretions.  Wherever  proprietorship  resides 
in  more  than  one  individual  it  is  essential  that  careful  accounting 
methods  be  observed.  In  such  cases  there  is  always  a  possible 
clash  of  interests,  and  the  equity  of  one  or  more  of  the  firm  mem- 
bers may  be  jeopardized  if  complete  proprietary  accounts  are 


26o  PRINCIPLES  OF  ACCOUNTING 

not  kept.  This  matter  is  of  still  greater  importance  in  the  case 
of  the  corporation,  where  in  addition  to  numerous  individual 
owners  may  be  found  different  classes  of  proprietors  and  other 
investors. 

Many  special  legal  and  accounting  problems  arise  in  connec- 
tion with  the  relations  between  partners  as  regards  interest 
charges,  loans,  distribution  of  assets,  etc.  Some  simple  illus- 
trations will  be  considered  in  the  following  section. 

SPECIAL  PROBLEMS   IN  PARTNERSHIP  ACCOUNTING 

In  certain  cases  questions  arise  as  to  the  correct  presentation 
of  the  partners'  accounts  at  the  time  of  organization.  The 
transition  from  a  single-proprietorship  to  a  partnership  will 
serve  as  an  illustration.  A,  it  will  be  assumed,  is  a  proprietor 
engaged  in  the  retail  trade.  The  balance  sheet  of  his  business, 
in  summary  form,  appears  as  follows  : 

Assets  (at  book  value)      .    $40,000      A,  Capital $40,000 

A  now  agrees  with  B  to  form  a  partnership.  No  new  assets  are 
contributed  to  the  business,  but  B  pays  A  personally  $15,000  for 
a  half-interest  in  the  enterprise.  Since  A  and  B  are  now  equal 
partners  the  proprietary  accounts  should  show  equal  balances. 
The  following  balance  sheet  would  be  consistent  with  this  situa- 
tion: 

Assets $40,000      A,  Capital $20,000 

B,  Capital 20,000 

$40,000  $40,000 

If  the  price  which  B  pays  for  an  equity,  however,  be  considered 
as  a  reasonable  criterion  of  the  value  of  the  assets  of  the  business, 
it  is  evident  that  the  book  value  of  these  assets  is  overstated  by 
$10,000.  If  certain  of  these  assets,  merchandise,  for  example, 
were  written  down  by  this  amount  the  first  balance  sheet  would 
appear  as  follows : 

Assets $30,000      A,  Capital $15,000 

B,  Capital 15,000 

$30,000  $30,000 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      261 

A  somewhat  different  situation  arises  if  it  be  assumed  that  B 
purchases  an  equal  interest  with  A  by  contributing  to  the  business 
cash  to  the  amount  of  $50,000.  If  the  old  assets  be  considered 
as  worth  $40,000,  the  first  partnership  balance  sheet  would  ap- 
pear as  follows : 

Sundry  Assets     ....    $40,000      A,  Capital       .    .     .     .     .    $45,000 

Cash •    .      50,000      B,  Capital 45,ooo 

$90,000  $90,000 


It  might  be  assumed  that  the  premium  which  B  pays  for  his 
equity  in  this  case  is  due  to  goodwill,  an  intangible  asset  belong- 
ing to  the  original  business  but  not  appearing  in  the  accounts. 
A  more  reasonable  procedure,  according  to  this  assumption, 
would  be  to  set  up  the  assets  and  partners'  accounts  as  shown  in 
the  following  balance  sheet : 

Sundry  Assets     ....    $40,000      A,  Capital $50,000 

Goodwill 10,000      B,  Capital 50,000 

Cash 50,000 

$100,000  $100,000 

It  is  evident  from  the  foregoing  simple  illustrations  that  the 
original  investment  of  a  partner,  as  shown  by  his  capital  account, 
may  not  coincide  with  the  actual  amount  contributed.  In  other 
words  the  purchase  price  of  a  definite  fraction  of  the  proprietary 
interest  may  not  be  consistent  with  the  asset  values  as  stated. 
This  is  particularly  likely  to  be  the  case  where  one  partner,  with 
the  consent  of  the  other  members  of  the  firm,  sells  a  part  or  all 
of  his  equity  to  an  outside  party  who  brings  in  no  new  capital. 
As  long  as  the  proper  proportions  are  maintained  in  the  part- 
ners' accounts,  however,  a  revision  of  the  asset  values  is  not  an 
imperative  matter.  The  purchase  and  sale  price  of  a  share  in 
proprietorship  in  the  case  of  a  partnership  is  little  more  likely 
to  indicate  the  actual  value  of  the  firm's  assets  than  is  the  price 
of  a  share  of  stock  in  the  case  of  a  corporation  a  reliable  index  at 
all  times  of  the  value  of  the  corporation's  assets. 

As  stated  in  the  preceding  section  a  partner  may  have  debtor 
and  creditor  relations  with  the  firm  as  an  outsider  as  well  as  in 
the  capacity  of  a  proprietor.  A  partner  may  loan  funds  to  the 
firm  or  borrow  from  the  firm.  Such  transactions  should  be  kept 


262  PRINCIPLES  OF  ACCOUNTING 

carefully  distinct  from  the  regular  proprietary  transactions. 
The  rights  of  the  partner  as  an  outsider  have  a  different  legal 
status  in  the  event  of  dissolution  as  compared  with  his  rights  as 
a  proprietor.  Further,  since  the  division  of  profits  is  often  based 
directly  upon  the  proportions  which  the  amounts  appearing  in 
the  individual  proprietary  accounts  respectively  bear  to  total 
proprietorship,  it  is  essential  that  actual  proprietary  transactions 
be  segregated. 

Suppose,  for  example,  that  A,  a  partner,  loans  $5,000  to  the 
firm  on  the  firm's  promissory  note  (of  which  A  himself  may  be  a 
signer).  This  sum  should  be  credited  to  Notes  Payable  rather 
than  to  A,  Capital.  Similarly  if  A  borrows  $5,000  in  cash  from 
the  firm  on  his  personal  note  the  transaction  would  be  viewed 
as  an  exchange  of  assets  and  not  a  subtraction  from  A's  invest- 
ment. The  entries  in  this  case  would  be : 

Notes  Receivable $5,ooo 

Cash $5,ooo 

It  should  be  observed  that  in  certain  extreme  cases  rather 
artificial  accounting  situations  may  arise  if  there  is  a  strict  ad- 
herence to  the  distinction  between  transactions  with  the  part- 
ners as  outside  individuals  and  transactions  with  the  partners 
as  proprietors.  The  following  balance  sheet  illustrates  such  a 
situation : 

Loans  to  A $20,000      A,  Capital $20,000 

Loans  to  B 20,000      B,  Capital 20,000 

$40,000  $40,000 

Obviously  the  partnership  whose  condition  is  represented  by  this 
statement  has  virtually  ceased  to  exist  as  a  business  enterprise. 
It  really  has  no  assets  and  no  equities.  The  loans  to  partners 
are  essentially  withdrawals  of  proprietary  investment.  The 
business  has  been  liquidated.  Although  this  statement  rep- 
resents a  very  unlikely  situation,  it  serves  to  suggest  a  certain 
aspect  of  these  internal  relationships.  The  entity  of  the  busi- 
ness enterprise  should  not  be  insisted  upon  too  rigidly.  One 
must  be  careful  not  to  allow  formal  accounting  entries  to  obscure 
the  realities  of  a  situation. 
Similarly  in  connection  with  interest  on  loans  to  partners 


SINGLE-PROPRIETORS'   AND   PARTNERS'  ACCOUNTS      263 

peculiar  situations  may  appear.  Suppose,  for  example,  that 
A,  a  partner,  has  borrowed  $5,000  from  the  firm  on  a  six  per  cent 
note.  At  the  end  of  a  year  it  is  agreed  among  the  partners  that 
the  amount  of  interest  due  on  A's  note,  $300,  shall  be  charged 
to  A's  proprietary  account  since  A  is  not  in  a  position  to  make  a 
cash  payment.  The  entries  recognizing  this  transaction  would 
be: 

A,  Capital $300 

Interest $300 

The  credit  to  Interest  is  apparently  a  revenue  item,  and  it  would 
in  practice  be  handled  in  the  accounts  as  would  any  interest 
revenue.  It  should  be  recognized,  however,  that  this  item  is 
not  actual  revenue,  but  should  be  used  to  adjust  original  pro- 
prietorship between  the  partners.  This  may  be  made  clear  by 
an  examination  of  supposititious  balance  sheets  as  affected  by 
this  single  transaction.  The  balance  sheet  at  the  time  the  loan 
is  made,  it  will  be  assumed,  appears  as  follows  : 

Sundry  Assets     ....    $25,000      A,  Capital $15,000 

A's  Note         5,000      B,  Capital 15,000 

$30,000  $30,000 


Assuming  that  the  partners  share  in  all  income  in  proportion  to 
their  capital  account  balances  —  or  equally  in  this  case  —  the 
interest  revenue  shown  in  the  above  entry  would  be  distributed 
between  the  partners  by  the  following  entries : 

Interest $300 

A,  Capital r $150 

B,  Capital 150 

The  net  result  of  this  transaction,  therefore,  is  a  decrease  in  A's 
equity  of  $150  and  an  increase  in  B's  ownership  of  the  same 
amount.  The  resulting  balance  sheet  would  show  the  following 
condition : 

Sundry  Assets     ....    $25,000      A,  Capital $14,850 

A's  Note 5,000      B,  Capital 15,150 

$30,000  $30,000 

There  has  been  no  increase  in  total  assets  or  in  total  equities. 
Obviously,  therefore,  no  revenue  has  been  realized.  This  il- 


264  PRINCIPLES  OF  ACCOUNTING 

lustrates  the  importance  of  keeping  out  of  the  ordinary  interest 
accounts  interest  transactions  which  result  simply  in  adjust- 
ments between  partners.  If  such  interest  debits  and  credits 
are  included  in  one  account  with  ordinary  interest  entries  erro- 
neous conclusions  are  likely  to  be  drawn.  An  appropriate  pro- 
cedure in  the  above  case,  for  example,  would  be  to  omit  the 
entries  in  the  Interest  account.  In  this  event  the  transaction 
would  be  journalized  as  follows : 

d) 
A,  Capital $300 

A,  Capital $150 

B,  Capital 150 

or,  simply, 

(2) 

A,  Capital $150 

B,  Capital $150 

In  some  cases  the  articles  of  agreement  specify  that  interest 
shall  be  charged  on  deficiencies  and  credited  on  excesses  as  shown 
by  the  partners'  capital  accounts.  In  other  words  if  a  par- 
ticular partner's  drawings  are  excessive  and  reduce  his  equity 
below  the  original  capital  contribution,  his  capital  account  may 
be  charged  with  interest  at  a  specified  rate  on  the  amount  of  the 
deficiency ;  and  if  another  partner  allows  his  equity  to  accumu- 
late above  the  stipulated  investment  his  capital  account  may  be 
credited  with  interest  on  the  amount  of  the  excess.  Such  items 
of  interest  are  likewise  adjustments  in  proprietorship  between 
partners,  and  neither  represent  deductions  from  net  revenue 
nor  actual  additions  to  revenue  earned  as  the  case  may  be.  It 
is  sometimes  said  that  such  items  should  be  carried  to  the  or- 
dinary interest  account  and  should  be  treated  as  interest  on 
regular  loans.  This  fallacious  opinion  is  due  to  a  too  rigid  em- 
phasis upon  the  distinction  between  the  partner  as  an  outsider 
and  as  a  proprietor. 

As  was  explained  in  the  preceding  section  the  computation  of 
interest  on  the  partners'  equities  is  sometimes  required  by  the 
particular  provisions  in  the  agreement  concerning  the  distribu- 
tion of  net  income.  In  such  a  case  residual  income  (after  in- 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      265 

terest  allowances  are  distributed)  is  usually  divided  upon  some 
other  basis.  Such  agreements  are  common  in  cases  where  the 
functions  of  the  several  partners  are  quite  different.  A  managing 
"junior"  partner,  for  example,  who  invests  very  little  capital, 
may  be  entitled  according  to  the  partnership  contract  to  a  liberal 
percentage  of  residual  profits  after  the  other  partners  have  been 
allowed  a  certain  rate  upon  their  investments.  Such  a  partner 
is  essentially  a  manager,  and  the  profit  he  receives  is  really  the 
wages  of  management.  Sometimes  the  more  active  partner  is 
allowed  a  definite  salary  before  any  distribution  of  profit  is  made. 
Such  a  salary  is  a  part  of  the  earnings  of  the  partnership,  as  a 
business  unit,  and  if  charged  to  expense  simply  restricts  the 
stated  net  proprietary  income  to  a  return  on  capital  (pure  interest 
and  profit).  As  was  stated  in  a  preceding  chapter,  however, 
such  charges  may  be  considered  legitimate  revenue  deductions 
when  for  tax  purposes  the  net  income  of  the  partnership  is  as- 
sessed on  the  same  basis  as  the  net  income  of  a  corporation  which 
buys  the  services  of  management  from  outsiders. 

Where  interest  adjustments  are  involved  the  distribution  of 
proprietary  income  may  require  rather  cumbersome  calculations. 
A  further  example  will  serve  to  suggest  the  nature  of  such  com- 
putations, and  to  illustrate  certain  other  complexities  which  may 
arise.  Suppose  that  A  and  B  form  a  partnership,  January  ist, 
each  investing  $12,000.  According  to  the  agreement  income  is 
to  be  divided  equally.  On  February  ist  it  is  decided  to  take  in 
another  partner,  C,  who  invests  $6,000.  The  articles  of  copart- 
nership are  amended  in  such  a  way  as  to  require  that  the  account 
of  each  partner  be  credited  at  the  close  of  the  current  year  with 
interest  at  a  six  per  cent  rate  on  his  net  investment  from  February 
ist  to  the  end  of  the  year.  The  agreement  stipulates  that  all 
residual  income  shall  be  divided  in  proportion  to  the  actual 
equities  of  the  partners  as  they  appear  on  the  books  at  the  end 
of  the  year,  before  any  distribution  of  income  has  been  made. 
It  is  further  agreed  that  the  income  for  the  month  of  January 
shall  be  considered  as  one-twelfth  of  the  total  for  the  year,  and 
is  to  be  divided  equally  between  A  and  B  according  to  the  terms 
of  the  original  contract. 

During  the  year  B's  drawings  are  as  follows :  May  ist,  $350 ; 
August  15th,  $450;  December  ist,  $200.  A  and  C  make  no 


266  PRINCIPLES  OF  ACCOUNTING 

withdrawals  whatever.  On  December  3ist,  accordingly,  the 
partners'  equities  stand  on  the  books  as  follows:  A,  $12,000; 
B,  $11,000;  C,  $6,000.  Net  proprietary  income,  it  will  be  as- 
sumed, amounts  to  $3,600.  The  first  step  in  distributing  this 
amount  according  to  the  above  stipulations  is  to  divide  one- 
twelfth  of  the  total  equally  between  A  and  B.  The  entries 
would  be  as  follows : 

Net  Revenue $300 

A,  Capital $150 

B,  Capital 150 

Interest  must  now  be  computed  at  six  per  cent  on  each  partner's 
net  investment  for  eleven  months.  The  equities  of  A  and  C 
have  remained  unchanged  at  $12,000  and  $6,000,  respectively. 
The  interest  on  $12,000  for  eleven  months  is  $660,  and  on  $6,000 
for  the  same  period,  $330.  B,  however,  has  withdrawn  $1,000 
at  various  times.  A  convenient  way  to  compute  the  interest 
allowance  of  this  partner  is  to  subtract  from  $660  —  the  amount 
of  interest  had  his  investment  remained  unchanged  from  Feb- 
ruary ist  —  the  interest  on  $350  for  eight  months  (from  May  ist 
to  December  3 ist)  plus  the  interest  on  $450  for  four  and  one- 
half  months  plus  the  interest  on  $200  for  one  month.  This 
computation  gives  $635.88,  B's  interest  allowance.  The  entries 
recognizing  these  allowances  would  be  as  follows : 

Net  Revenue $1,625.88 

A,  Capital $660.00 

B,  Capital 635.88 

C,  Capital 330.00 

The  balance  of  the  net  income,  $1,674.12,  is  to  be  distributed 
in  proportion  to  the  partners'  equities  as  they  appear  on  the 
books  before  any  income  distributions  are  made.  This  sum  will 
then  be  divided  as  follows :  twelve  twenty-ninths  to  A ;  eleven 
twenty-ninths  to  B ;  and  six  twenty-ninths  to  C.  The  entries 
recognizing  this  residual  income  distribution  would  be : 

Net  Revenue $1,674.12 

A,  Capital $692.74 

B,  Capital 635.01 

C,  Capital 346.37 


SINGLE-PROPRIETORS'  AND   PARTNERS'  ACCOUNTS      267 

The  partnership  balance  sheet,  it  may  be  assumed,  now  ap- 
pears as  follows : 

Sundry  Assets     ....    $32,600      A,  Capital  ....  $13,502.74 

B,  Capital  ....  12,420.89 

C,  Capital  ....  6,676.37 

$32,600  $32,600.00 

Although  the  above  case  illustrates  a  purely  hypothetical 
situation,  it  should  be  recognized  that  a  great  variety  of  agree- 
ments and  arrangements  are  found  in  partnership  contracts ; 
and  where  the  partners'  account  balances  are  irregular  some 
rather  elaborate  calculations  may  be  necessary  in  distributing 
income. 

As  was  implied  in  the  preceding  section  any  change  in  the 
personnel  of  a  partnership  virtually  causes  the  dissolution  of 
the  firm.  Where  a  partner  voluntarily  retires  and  sells  his 
interest  the  change  may  not  mean  an  actual  liquidation  of  the 
business.  Such  a  change  from  the  accounting  standpoint  may 
be  largely  of  nominal  significance.  But  in  the  case  of  bank- 
ruptcy, or  dissolution  by  court  decree  for  other  reason,  the  firm 
as  a  business  enterprise  usually  ceases  to  exist.  In  such  a  case 
the  assets  are  applied  first  to  the  payment  of  the  liabilities,  and 
any  balance  is  then  available  for  distribution  among  the  part- 
ners. Any  advances  made  by  a  partner  to  the  firm  must  be  met 
before  the  capital  shares  are  distributed. 

Unless  the  articles  contain  specific  provisions  in  regard  to  dis- 
solution some  question  may  arise  as  to  how  the  residual  assets 
should  be  divided  in  certain  cases.  Should  the  proportions  shown 
by  the  original  capital  contributions  of  the  partners  be  used,  or 
should  the  distribution  be  based  upon  the  balances  finally  appear- 
ing in  the  partners'  accounts?  The  partnership  agreement 
should  cover  this  point.  In  some  cases  the  articles  specify  that 
losses  shall  be  borne  equally  by  all  partners,  although  the  in- 
vestments are  unequal  and  some  other  basis  is  used  in  distribut- 
ing income.  As  an  illustration  .of  a  dissolution  on  this  basis  it 
will  be  convenient  to  refer  to  the  case  discussed  above.  Suppose 
that  after  three  years  it  is  decided  to  dissolve  the  partnership 
because  of  serious  losses  and  poor  business  prospects.  The 
balance  sheet  at  this  time,  it  will  be  assumed,  stands  as  follows : 


268  PRINCIPLES  OF  ACCOUNTING 

Sundry  Assets     ....    $21,000      A,  Capital $12,000 

Deficit 9,000      B,  Capital 12,000 

C,  Capital 6,000 

$30,000  $30,000 


Suppose  further  that  the  agreement  provides  that  all  losses  are 
to  be  borne  equally.  The  account  of  each  partner,  then,  would 
be  charged  with  one-third  of  $9,000,  or  $3,000.  The  entries 
would  be : 

A,  Capital $3,000 

B,  Capital 3,000 

C,  Capital 3,000 

Deficit $9,000 

The  resulting  balance  sheet  would  now  show  the  following 
condition : 

Sundry  Assets     ....    $21,000      A,  Capital $  9,000 

B,  Capital  9,000 

C,  Capital 3,ooo 

$21,000  $21,000 

The  assets  may  now  be  distributed  according  to  the  amounts 
appearing  in  the  partners'  accounts. 

The  transition  from  the  partnership  to  the  corporate  form  of 
organization  is  often  a  complex  accounting  transaction.  This 
situation  will  be  discussed  in  the  following  chapter  on  corporate 
proprietorship. 


XII 

CORPORATE  PROPRIETORSHIP  —  CAPITAL  STOCK 

IT  has  been  noted  several  times  in  the  preceding  chapters  that 
the  corporation  is  the  most  important  form  of  business  organi- 
zation with  which  the  accountant  has  to  deal.  The  large  scale 
enterprise  which  may  be  said  to  be  typical  of  modern  industry 
is  usually  organized  under  the  corporate  form,  and  it  is  in  connec- 
tion with  the  complex  equipment  of  such  large  enterprises  that 
the  more  difficult  problems  of  valuation  arise.  Further,  a  cor- 
rect periodic  presentation  of  the  status  of  the  rights  of  owner- 
ship is  a  matter  of  particular  importance  in  the  case  of  the  cor- 
poration because  of  the  large  number  of  individual  investors 
involved  in  the  typical  case,  and  also  because  of  the  different 
classes  of  equities  represented.  The  detachment  of  the  investor 
from  the  immediate  management  of  the  affairs  of  the  corpora- 
tion, and  the  transient  character  of  many  of  the  individual 
owners,  are  other  factors  contributing  to  the  need  for  adequate 
corporation  accounting.  In  this  chapter  and  the  next  the  nature 
of  corporate  proprietorship  and  proprietary  accounts  will  be 
discussed.  In  the  present  chapter  typical  transactions  affecting 
Capital  Stock  and  related  accounts  will  be  explained.  Some 
attention  will  be  given  to  the  peculiar  features  of  the  corporate 
form  of  organization,  and  to  the  special  books  and  records 
required.  Chapter  XIII  will  be  devoted  to  a  discussion  of  the 
surplus  accounts. 


The  private  business  corporation  (to  which  the  discussion  in 
this  text  will  be  largely  confined)  is  like  the  partnership  an  associ- 
ation of  persons  formed  primarily  for  the- pecuniary  profit  of  its 
members.  The  corporation,  however,  differs  from  the  partner- 

260 


270  PRINCIPLES  OF  ACCOUNTING 

ship  in  several  marked  respects.  Whether  created  by  special 
act  or  charter  or  by  general  law  the  corporation  is  endowed  by 
the  state  or  government  with  the  power  of  acting  in  many  re- 
spects as  a  single  individual.  In  fact,  from  a  legal  point  of  view, 
the  corporation  is  an  artificial  being  possessing  an  existence 
separate  and  distinct  from  that  of  its  individual  members.  The 
universal  recognition  by  the  courts  of  the  reality  of  this  corporate 
entity  is  a  matter  of  very  considerable  importance.  It  means 
that  a  corporation,  having  a  legal  existence  distinct  from  that  of 
its  members,  is  not  dissolved  by  changes  in  the  personnel  of  its 
membership,  as  is  the  partnership,  due  to  the  death  or  withdrawal 
of  individual  members  and  the  substitution  of  others.  The 
entire  membership  of  a  corporation  might  be  changed  any  num- 
ber of  times  and  still  the  legal  existence  of  the  organization  would 
not  be  disturbed.  It  follows  that  the  legal  title  to  the  corporate 
property  resides  in  the  corporation  itself,  and  not  in  its  mem- 
bers as  individuals,  either  separately  or  collectively.  In  general, 
moreover,  the  liabilities  incurred  and  the  engagements  made  in 
the  corporate  name  are  the  obligations  of  the  corporation  alone, 
and  bind  only  its  assets  or  property  and  not  the  assets  of  indi- 
vidual members,1  while  in  the  case  of  the  partnership  —  as  was 
explained  in  the  preceding  chapter  —  the  law  regards  the  rela- 
tion of  the  members  as  a  purely  contractual  one,  and  each  part- 
ner is  held  personally  responsible  for  all  of  the  liabilities  and 
contracts  of  the  partnership.  This  fact  of  limited  liability  is 
one  of  the  chief  advantages  of  the  corporate  form  as  a  means  of 
attracting  the  capital  of  the  investor. 

A  corporation  is  most  commonly  incorporated  under  a  general 
law  authorizing  such  organizations.  The  original  promoters 
and  other  parties  interested  meet  and  agree  upon  a  plan  of  action. 
Usually  at  this  first  meeting  a  part  of  the  authorized  capital 
stock  is  subscribed  for,  and  an  organization  is  effected  by  the 
election  of  a  board  of  directors  and  other  officers.  Articles  of 
association  are  then  prepared  and  the  other  necessary  legal  steps 
to  initiate  the  enterprise  are  taken. 

1  In  certain  special  cases  there  are  exceptions  to  the  rule  that  a  corporate  member 
is  liable  only  for  the  amount  of  his  investment.  The  stockholders  of  national  bank- 
ing companies  are  liable  for  twice  the  par  value  of  their  stock.  Some  states  also 
have  laws  restricting  the  limited  liability  privilege  in  general. 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     271 

The  members  of  the  ordinary  stock  corporation  are  the  stock- 
holders, and  it  is  the  equity  of  the  stockholders  which  constitutes 
corporate  proprietorship.  It  is  therefore  the  proprietary  equity 
in  the  corporation  as  well  as  in  other  types  of  organization  which, 
in  law,  represents  ownership  par  excellence.  The  authorized 
capital  stock  is  the  amount  fixed  by  the  charter  or  articles  of 
incorporation  as  a  basis  for  the  contributions  of  the  stockholders. 
The  total  capital  stock  is  divided  into  aliquot  parts  called  shares. 
The  equity  of  each  stockholder  is  evidenced  by  the  number  of 
shares  he  holds.  A  share  of  stock,  as  was  implied  above,  does  not 
constitute  a  title  to  any  specific  asset  of  the  corporation,  but  it 
represents  a  certain  fraction  of  total  proprietorship,  and  thus 
carries  with  it  certain  rights  in  management,  income,  and  ulti- 
mate assets. 

The  number  of  shares  which  each  stockholder  has  in  the  cor- 
poration is  represented  by  a  stock  certificate,  signed  by  the 
proper  officers  of  the  company.  The  nature  of  such  a  certificate 
is  suggested  by  the  following  illustration. 

INTERNATIONAL   STEEL    COMPANY 

NUMBER  SHARES 

1120  100 

This  certifies  that  A.  W.  Rollins  is  the  owner  of  one  hundred  shares 
(par  value  ten  dollars)  of  the  capital  stock  of  the 

INTERNATIONAL   STEEL   COMPANY 

a  corporation  duly  organized  under  the  laws  of  the  state  of  Delaware. 
This  stock  is  transferable  on  the  books  of  the  Company  only  in  person  or 
by  attorney,  upon  the  return  of  this  certificate  properly  endorsed. 

In  Witness  Whereof,  the  said  company  has  caused  this  certificate  to  be 
signed  by  its  President  and  Secretary,  and  its  corporate  seal  to  be  affixed, 
at  the  office  of  the  company  at  Wilmington,  Delaware,  this  i5th  day  of 
August,  1918. 

JAMES  B.  HARLEY,  President. 
(SEAL)  S.  R.  WILSON,  Secretary-Treasurer 

FULLY    PAID    AND   NON-ASSESSABLE 

The  legal  holder  of  such  a  certificate  is  one  of  the  corporate  pro- 
prietors. Such  a  certificate  may  be  acquired  either  by  means 
of  a  contract  entered  into  directly  with  the  corporation  or  by 


272  PRINCIPLES  OF  ACCOUNTING 

purchasing  or  otherwise  securing  the  equity  of  someone  previously 
a  shareholder. 

The  stockholders  as  a  rule  are  not  active  in  the  management 
of  the  corporation,  while  the  proprietors  in  partnerships  and 
single-proprietorships  usually  are.  The  ultimate  authority 
resides  in  the  stockholders  but  active  management  is  vested  in 
a  board  of  directors  elected  by  the  stockholders  in  a  manner 
prescribed  by  law.  The  directors  are  usually  shareholders,  but 
not  always  large  shareholders.  A  set  of  rules  or  by-laws  approved 
by  the  stockholders  governs  in  a  general  way  the  conduct  of  the 
corporation's  business. 

Thus  far  in  the  discussion  of  corporate  organization  and  pro- 
prietorship it  has  been  assumed  that  the  membership  of  a  cor- 
poration is  a  congruous  body  of  stockholders ;  or,  in  other  words, 
corporate  ownership  has  been  identified  with  corporate  proprie- 
torship —  the  stockholder's  equity.  This  is  essentially  the  legal 
view ;  but  there  are  certain  important  developments  in  corpora- 
tion finance  which  make  it  essential  that  the  accountant  conceive 
of  the  corporation  as  a  business  enterprise  on  a  somewhat  broader 
basis.  In  the  first  place  there  may  be  more  than  one  kind  of 
capital  stock.  The  most  important  general  distinction  is  between 
common  and  preferred  stocks.  This  distinction  simply  carries 
one  step  further  the  important  division  of  the  elements  of  owner- 
ship explained  at  the  beginning  of  the  preceding  chapter.  The 
common  stock  represents  the  more  speculative  phase  of  proprie- 
torship, carrying  more  risk  and  frequently  greater  control.  In 
some  cases  the  common  stock  is  given  as  a  bonus  with  preferred 
stock  or  bonds,  and  in  such  a  case  its  value  is  purely  speculative. 

The  preferred  stock  may  be  preferred  either  as  to  income  or 
as  to  capital  in  case  of  liquidation;  and  in  many  cases  both 
provisions  obtain.  Usually  a  preferred  stock  carries  a  definite 
dividend  or  interest  rate.  The  stated  dividend  rate  applies  to 
the  par  or  face  value  of  the  stock.  A  seven  per  cent  preferred 
stock,  for  example,  is  entitled  to  an  annual  dividend  of  seven 
per  cent  on  par  before  any  dividends  are  declared  on  the  out- 
standing common  stock.  In  some  cases  the  dividend  privileges 
on  preferred  stock  lapse  at  the  end  of  each  year  provided  earn- 
ings are  insufficient  to  meet  them.  In  other  cases  the  stock  is 
"cumulative,"  and  all  unpaid  dividends  constitute  a  potential 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     273 

charge  against  net  revenue  prior  to  the  common  stockholders' 
claims.  In  fact  there  is  almost  an  indefinite  variety  of  preferred 
stocks  to  be  found  in  practice. 

It  is  not  intended  here  to  dwell  in  detail  upon  the  many  pos- 
sible plans  which  may  be  followed  in  dividing  among  different 
classes  of  stockholders  the  important  aspects  of  proprietorship 
as  regards  income,  control,  etc.  The  fact  that  this  division  of 
rights,  however,  is  not  only  a  possibility  but  a  widespread  and 
growing  practice,  is  a  consideration  which  has  an  important 
bearing  upon  the  accountant's  conception  of  the  corporation 
balance  sheet.  This  point  will  be  further  emphasized  in  a 
moment. 

A  corporate  organization  commonly  makes  use  of  other  securi- 
ties than  stocks  in  securing  the  capital  necessary  to  the  success- 
ful initiation  of  the  enterprise  as  a  business  unit.  Various  kinds 
of  bonds  are  the  most  familiar  examples.  These  other  securities, 
together  with  the  current  or  floating  indebtedness,  constitute 
the  liabilities  of  the  corporation.1  According  to  the  conception 
of  the  balance  sheet  stressed  in  the  foregoing  pages  these  lia- 
bilities also  represent  equities  in  the  enterprise.  The  economic 
distinction  between  entrepreneur  and  capitalist  proper  already 
referred  to  corresponds  roughly  to  the  distinction  between  stock- 
holder and  bondholder.  The  stockholder  assumes  the  larger 
element  of  risk  in  the  enterprise  and  has  the  larger  element  of 
control.  The  stockholder  profits  most  if  the  business  is  very 
successful ;  and  he  suffers  first  if  the  enterprise  is  disastrous. 
Accordingly  the  stockholder,  as  was  stated  above,  is  the  pro- 
prietor and  his  equity  constitutes  proprietorship.  The  bond- 
holder's equity  is  classed  among  the  liabilities  proper.  It  should 
be  emphasized,  however,  that  the  distinction  between  pro- 
prietorship and  liabilities  is  in  general  much  less  sharp  in  the 
corporation  than  in  the  case  of  the  simpler  forms  of  organization. 
In  reality  the  strictly  legal  view  which  looks  upon  the  stockholders 
as  forming  the  membership  of  a  corporation  is  a  somewhat  narrow 
conception  for  the  accountant.  From  the  accounting  standpoint 
there  is  at  least  some  reason  for  thinking  of  all  the  individuals 
who  furnish  capital  to  the  corporation  as  constituting  the  cor- 
porate membership. 

1  The  corporate  liabilities  will  be  more  fully  discussed  in  Chapter  XIV. 
T 


274  PRINCIPLES  OF  ACCOUNTING 

This  view  seems  the  more  reasonable  when  the  tendency 
toward  the  further  specialization  of  securities,  both  stocks  and 
bonds,  is  recognized.  This  tendency  makes  it  difficult  to  main- 
tain in  the  case  of  the  corporation  the  sharp  distinction  drawn 
between  proprietorship  and  liabilities,  which  is  fairly  applicable 
to  the  simpler  forms  of  organization.  It  cannot  be  said,  for 
example,  that  the  fact  that  bonds  have  definite  repayment  dates 
places  such  securities  in  an  altogether  distinct  category.  Pre- 
ferred stocks  are  often  callable  under  specific  conditions  and  at 
specific  dates,  and  are  liquidated  in  cash  or  exchanged  for  other 
securities.  Again,  perpetuities,  which  are  virtually  bonds  with- 
out payment  dates,  are  sometimes  issued.  The  use  of  such 
instruments  in  the  United  States  will  probably  increase  as  the 
country  becomes  older  and  the  opportunities  for  speculative 
investment  become  less  numerous.  Further,  a  large  bond  issue 
is  usually  paid  by  refunding,  and  although  the  personnel  of  the 
investors  may  change  this  in  a  sense  makes  the  issue  perpetual. 
Still  further,  it  is  quite  possible  to  finance  an  entire  terminable 
project  with  stock  issues.  The  stock  of  a  wasting  asset  enterprise, 
such  as  a  lumbering  company,  may  be  liquidated  in  a  definite 
manner  according  to  stipulations  in  the  articles  of  incorporation. 
Incorporated  philanthropic  societies  and  similar  organizations 
also  frequently  terminate  after  a  specified  number  of  years  and 
the  capital  stock  is  retired  at  that  time  by  definite  arrangement. 

A  general  legal  distinction  between  stocks  and  bonds  of  con- 
siderable importance  lies  in  the  fact  that  legal  bankruptcy  ensues 
if  bond  interest  is  defaulted,  whereas  in  the  case  of  stocks  such 
a  thing  is  not  possible.  This  distinction  again,  however,  is  not 
as  sharp  as  the  division  between  proprietorship  and  liabilities 
in  the  case  of  the  small  firm.  The  vast  property  of  a  modern 
corporation  cannot  be  sold  under  the  hammer.  Bankruptcy 
in  such  cases  means  primarily  reorganization ;  and  in  such  a 
reorganization  all  of  the  equities  involved  in  the  capitalization 
of  the  business  play  parts  according  to  their  particular  privileges 
and  burdens.  Further  it  might  be  noted  that  a  consistent  fail- 
ure to  pay  cumulative  preferred  dividends  may  force  a  reorgani- 
zation.1 Finally  it  should  be  remembered  that  any  individual 

1  For  an  example  see  the  history  of  the  United  States  Leather  Company  in  Dew- 
ing, Corporate  Promotions  and  Reorganizations,  Chapter  II. 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     275 

stockholder  has  definite  legal  rights  of  procedure  against  the  cor- 
poration in  which  he  has  an  equity  provided  his  privileges  are 
being  impaired  ;  and  because  of  the  importance  of  the  corporate 
entity  such  rights  are  of  much  greater  significance  than  the 
similar  rights  of  a  partner. 

In  the  matter  of  control  it  should  be  observed  that  the  bond- 
holder frequently  has  considerable  direct  and  indirect  influence 
upon  the  management  of  the  corporation.  Stipulations  in  regard 
to  sinking  fund  appropriations,  new  security  issues,  general 
financial  policies,  etc.,  are  of  common  occurrence  in  the  bond 
contract.  The  bondholder  sometimes  has  voting  and  veto 
powers  in  regard  to  important  measures.  Another  point  of 
importance  in  this  connection  is  the  fact  that  the  bondholders 
come  into  direct  control  in  receiverships  and  reorganizations. 
Further,  in  reorganizations  wholesale  exchanges  of  bonds  for 
stocks  (the  reverse  operation  is  also  common)  occur.  Stock- 
holders pass  into  the  bondholder  class,  and  bondholders  become 
stockholders.  This  is  also  a  fairly  common  kind  of  financial 
operation  outside  of  reorganizations.  Some  issues  of  bonds  give 
the  holder  the  privilege  of  exchanging  his  security  for  stock  under 
certain  specified  conditions.  This  feature  is  particularly  common 
in  the  bond  issues  of  mining  corporations.  The  convertibility 
of  bonds  sometimes  means  that  interests  represented  for  a  time 
at  least  among  the  bondholders  have  a  potential  majority  control 
of  the  corporation. 

In  fact  if  all  existing  varieties  of  corporate  securities  were  ar- 
ranged in  a  series  beginning  with  the  speculative  kinds  of  common 
stocks,  and  ending  with  the  conservative  types  of  bonds  and 
similar  securities,  it  would  be  impossible  to  group  these  equities 
between  proprietorship  and  liabilities  on  any  hard  and  fast 
basis.  Certainly  it  would  be  somewhat  unreasonable  to  classify 
the  series  into  two  divisions,  one  representing  ownership  and  the 
other  debts.  It  must  be  remembered,  however,  that  the  unit 
with  which  accounting  deals  is  the  specific  enterprise,  rather 
than  corporations  or  securities  in  general,  and  that  in  the  specific 
case  the  distinction  between  corporate  proprietorship  and  cor- 
porate liabilities  is  usually  a  matter  of  considerable  practical 
significance. 

It  is  evident  that  the  need  for  complete  proprietary  and  other 


276  PRINCIPLES  OF  ACCOUNTING 

equity  accounts  in  the  case  of  the  corporation  is  imperative.  It 
is  not  enough  to  be  able  to  ascertain  total  proprietorship  at  any 
moment  by  subtracting  the  amount  of  the  liabilities  from  the 
total  of  property.  If  the  rights  of  the  different  classes  of  stock- 
holders and  other  interests  are  to  be  preserved  specific  accounts 
must  be  kept  which  show  the  status  of  each  equity.  Further, 
an  elaborate  system  of  expense  and  revenue  and  other  subsidiary 
equity  accounts  is  a  matter  of  particular  importance  in  the  case 
of  the  large  scale  enterprise  where  several  interests  are  concerned. 
The  accounts  representing  corporate  proprietorship  are  af- 
fected primarily  at  times  of  organization,  merger,  dissolution, 
etc.,  and  by  the  process  of  distributing  net  revenue,  subdividing 
surplus,  and  the  like.  -The  transactions  requiring  entries  in 
Capital  Stock  and  related  accounts  arise  for  the  most  part  at  the 
time  of  organization.  Such  transactions  will  be  discussed  in 
the  following  sections. 

THE   TRANSITION  FROM   PARTNERSHIP   TO   CORPORATION 

The  organization  of  a  corporation  frequently  represents  a 
change  from  the  partnership  form.  A  simple  illustration  of  such 
a  situation  will  be  considered.  The  balance  sheet  of  A  and  B, 
partners,  it  will  be  assumed,  shows  the  following  condition : 

ASSETS  EQUITIES 

Plant $50,000      A,  Capital  Account       .     .    $22,000 

Machinery 10,000      B,  Capital  Account       .     .      38,000 

Supplies 2,500      Notes  Payable     ....        6,500 

Patents 2,700      Accounts  Payable    .     .     .        2,600 

Accounts  Receivable    .     .  1,800 

Notes  Receivable     .     .     .  600 

Cash 1,500 

$69,100  $69,100 


The  A.  B.  Co.,  a  corporation,  is  organized  for  the  purpose  of 
taking  over  the  assets  of  the  old  partnership  and  expanding  the 
business.  According  to  the  terms  of  the  purchase,  all  the  assets 
of  the  partnership  are  to  be  taken  over  at  their  book  value,  and 
all  the  liabilities  are  to  be  assumed  by  the  new  concern  as  they 
stand.  Capital  stock  is  authorized  for  $100,000,  par  value  $100 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     277 

per  share.  The  partners  are  to  receive  $75,000  in  stock  for  their 
equities  in  the  partnership.  It  will  be  assumed  that  this  agree- 
ment is  consummated.  What  would  be  the  closing  entries  on 
the  books  of  the  partnership? 

This  agreement  involves  the  recognition  of  goodwill.  The 
partners'  equities  stand  on  the  books  at  $60,000.  They  are  to 
receive  $75,000  in  the  stock  of  the  new  enterprise.  This  situation 
almost  invariably  arises  when  a  partnership  is  taken  over  by  a 
corporation.  The  par  value  of  the  securities  received  by  the 
partners  usually  exceeds  the  book  value  of  the  assets  of  the  firm. 
The  goodwill  may,  of  course,  be  entirely  legitimate,  due  to  a 
trade  name,  superior  selling  organization,  etc. ;  on  the  other  hand 
it  is  very  frequently  illegitimate.1  In  such  a  situation  the  value 
of  the  stock  received  must  be  tested  on  a  cash,  or  an  equivalent, 
basis.  Assuming  in  this  case  that  the  goodwill  is  authentic,then 
preliminary  entries  will  be  necessary  on  the  books  of  the  part- 
nership to  recognize  this  item.  The  amount  of  the  goodwill, 
it  will  be  assumed,  is  to  be  credited  to  the  partners'  capital  ac- 
counts in  proportion  to  their  investments.  The  entries,  accord- 
ingly, would  be  as  follows : 

Goodwill       $15,000 

A,  Capital  Account $5, 500 

B,  Capital  Account        9,Soo 

All  of  the  partnership  assets,  including  goodwill,  are  now  trans- 
ferred to  the  A.  B.  Co.,  and  the  liabilities  are  assumed  by  that 
company.  The  entries  covering  these  transactions  on  the  books 
of  the  partnership  would  be : 

(i) 

A.  B.  Co $84,100 

Plant $50,000 

Machinery 10,000 

Supplies 2,500 

Patents 2,700 

Accounts  Receivable 1,800 

Notes  Receivable 600 

Cash ijSoo 

Goodwill 15,000 

1  See  Chapter  XXIV  for  a  discussion  of  goodwill. 


278  PRINCIPLES  OF  ACCOUNTING 

which  recognizes   the   transfer  of  the  assets  to   the  corpora- 
tion ;   and, 


Notes  Payable    ..........    $6,500 

Accounts  Payable   .........      2,600 

A.  B.  Co  ..........  $9,100 

which  recognizes  the  assumption  of  the  partnership  liabilities 
by  the  A.  B.  Co.  The  balance  of  the  A.  B.  Co.  account  repre- 
sents the  claim  which  the  partners  have  against  the  newly 
organized  corporation. 

The  partners  receive  $75,000  in  the  capital  stock  of  the  A.  B. 
Co.  in  full  settlement  of  their  claim  against  the  corporation. 
The  entries  at  this  time  would  be  : 

Stock  —  A.  B.  Co  .........    $75,ooo 

A.  B.  Co.    .     .  t  .......  $75,000 

The  partnership  balance  sheet  would  now  show  this  condi- 
tion: 

Stock  —  A.  B.  Co.       .     .    $75,000      A,  Capital  Account       .     .    $27,500 

B,  Capital  Account       .     .      47,500 

$75,000  $7  5.  OOP 


The  final  step  in  liquidating  the  partnership  will  be  the  divi- 
sion of  the  capital  stock  received  between  the  partners  in  pro- 
portion to  their  investments,  and  the  closing  of  the  partnership 
accounts.  In  this  case  the  partners'  capital  accounts  are  such 
that  the  stock  can  be  divided  in  exact  proportion  to  the  balances 
shown  by  these  accounts.  Since  a  share  of  stock  cannot  be 
divided,  it  frequently  happens  that  one  partner  will  have  to  take 
an  extra  share,  paying  the  difference  in  cash.  In  this  case  A 
would  receive  275  shares,  and  B,  475  shares ;  and  the  final  closing 
entries  would  be.: 

A,  Capital  Account $27,500 

B,  Capital  Account 47,500 

Stock  — A.  B.  Co $75,ooo 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     279 

In  summary  form  the  opening  entries  on  the  books  of  the  A. 
B.  Co.  covering  the  transfer  of  the  partnership  assets  and  lia- 
bilities would  be  as  follows : 

(i) 

Plant $50,000 

Machinery 10,000 

Supplies 2,500 

Patents 2,700 

Accounts  Receivable 1,800 

Notes  Receivable 600 

Cash 1,500 

Goodwill 15,000 

A  and  B $84,100 

which  recognizes  the  transfer  of  the  assets  and  the  claims  of  A 
and  B ;   and, 

(2) 

A  and  B $9,100 

Notes  Payable       $6,500 

Accounts  Payable 2,600 

which  recognizes  the  transfer  of  the  liabilities. 

The  balance  of  the  A  and  B  account  shows  the  amount  of  stock 
due  the  partners.  The  stock  is  now  issued  to  A  and  B.  The 
entries  would  be : 

A  and  B $75,000 

Capital  Stock $75,ooo 


The  opening  entries  are  evidently  essentially  the  reverse  of  the 
partnership  closing  entries.  The  more  detailed  corporate  or- 
ganization entries  usually  necessary  will  be  illustrated  in  the 
next  section. 

If  the  balance  of  the  stock  authorized  were  now  sold  for  cash, 
the  opening  entries,  in  summary  form,  would  be  : 

Cash $25,000 

Capital  Stock $25,000 


280  PRINCIPLES  OF  ACCOUNTING 

A  balance  sheet  of  the  corporation  at  this  point  would  show 
this  condition : 


ASSETS  EQUITIES 


Plant        

$50,000 

Capital  Stock    . 

Machinery    .     .     .     . 

10,000 

Notes  Payable 

Supplies    

2,500 

Accounts  Payable 

Patents     

2,700 

Accounts  Receivable  . 

i,  800 

Notes  Receivable 

600 

Cash    

26,500 

Goodwill       .     .     .     . 

15,000 

$100,000 
6,500 
2,600 


$I09,IOO  $IOQ,IOO 

A  comparison  of  this  balance  sheet  and  the  original  partnership 
statement  shows  that  the  important  change  that  has  occurred  is 
in  the  proprietary  accounts.  The  property  accounts  stand  as 
they  did  before  (except  for  the  introduction  of  Goodwill  and  the 
increase  in  the  amount  appearing  in  Cash),  only  now  they 
are  on  the  ledger  of  the  corporation.  The  outside  equity  accounts 
show  no  change ;  but  in  place  of  the  partners'  capital  accounts 
there  appears  the  Capital  Stock  account  to  represent  proprietor- 
ship. This  illustrates  the  fact  that  the  type  of  organization 
adopted  in  any  case  affects  the  character  of  the  accounting  records 
primarily  in  the  equity  accounts. 


ORGANIZATION  —  STOCK  ISSUED  FOR  CASH 

The  opening  entries  in  the  case  of  the  organization  of  a  cor- 
poration are  usually  much  more  detailed  than  as  shown  in  the 
preceding  section.  Another  illustration  will  be  discussed  at  this 
point.  The  Blank  Company  is  incorporated  under  the  laws  of 
Michigan,  July  i,  1918.  The  company  plans  to  do  a  general 
manufacturing  business.  The  authorized  capital  is  $175,000, 
divided  into  1000  shares  of  common  stock,  par  $100,  and  750 
shares  of  preferred  stock,  par  $100.  At  the  time  of  incorpora- 
tion $50,000  of  common  stock  is  subscribed,  and  $25,000  of  pre- 
ferred. There  are  various  methods  of  making  the  journal  en- 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     281 

tries  necessary  to  recognize  this  situation.  The  entries  might 
have  this  form  : 1 

Subscriptions  (Common) $50,000 

Subscriptions  (Preferred) 25,000 

Stock  Subscribed  (Common)      .     .  $50,000 

Stock  Subscribed  (Preferred)      .     .  25,000 

A  subscription  for  capital  stock  is  of  the  nature  of  a  promissory 
note  and  hence  is  an  asset  of  the  corporation.  The  balance  of 
the  Stock  Subscribed  account  represents  the  promise  of  the  cor- 
poration to  issue  the  stock  when  the  subscriptions  are  paid. 

At  the  time  the  subscriptions  are  paid  the  journal  entries 
would  be : 

Cash   . $75,000 

Subscriptions  (Common)  ....  $50,000 

Subscriptions  (Preferred)  ....  25,000 

After  the  subscriptions  have  been  paid  in  cash  the  corporation 
is  required  to  issue  and  deliver  the  stock.  The  following  entries 
would  cover  this  transaction: 

Stock  Subscribed  (Common) $50,000 

Stock  Subscribed  (Preferred) 25,000 

Capital  Stock  (Common)       .     .     .  $50,000 

Capital  Stock  (Preferred)       .     .     .  25,000 

The  balance  of  stock  authorized  (both  common  and  preferred) 
is  now  sold  immediately  for  cash.  The  entries  would  be : 

Cash $100,000 

Capita).  Stock  (Common)     .     .     .  $50,000 

Capital  Stock  (Preferred)     ...        .  50,000 

If  the  balance  of  the  stock  authorized  had  been  subscribed,  and 
an  interval  had  elapsed  before  the  subscriptions  were  paid,  then 
the  additional  entries  involving  Subscriptions  and  Stock  Sub- 
scribed would  be  necessary.  This  is  practically  always  the  case. 
The  balance  sheet  of  the  Blank  Company  after  the  consumma- 

1  The  entries  given  in  these  cases  show  the  effect  of  the  various  transactions  only 
upon  the  controlling  proprietary  accounts  appearing  in  the  general  ledger  of  the 
corporation.  The  subsidiary  accounts  and  books  required  will  be  described  in  a 
later  section  of  the  chapter. 


282  PRINCIPLES  OF  ACCOUNTING 

tion  of  the  foregoing  transactions  would  show  the  following 
condition : 

Cash $175,000      Capital  Stock  (Common)    $100,000 

Capital  Stock  (Preferred)        75,ooo 
$175,000  $175,000 


It  has  been  assumed  in  this  and  in  the  preceding  illustration 
that  the  entire  authorization  of  the  capital  stock  was  issued  at 
one  price  —  par  value.  Very  frequently,  however,  capital 
stock  is  subscribed  at  some  price  other  than  par ;  and  in  the  case 
of  the  flotation  of  a  large  issue  several  different  prices  may  be 
involved.  In  such  cases  it  is  not  the  par  value  of  the  securities 
issued  that  represents  the  stockholders'  equity  but  the  amount  of 
the  actual  investment.  Par  value  is  then  largely  a  nominal 
fact ;  and  the  significance  which  the  investor  commonly  attaches 
to  this  fact  is  unwarranted.  Some  states  now  permit  the  is- 
suance of  capital  stock  without  a  par  value.  This  seems  an 
entirely  proper  practice.  Undoubtedly  the  investor  is  often 
misled  by  par  value  and  formal  capitalization.  These  facts 
give  little  clue  to  the  amount  of  the  actual  investment  and  the 
consequent  value  of  the  company's  property.  It  would  be  quite 
possible  to  enter  capital  stock  without  a  nominal  value  in  the 
accounting  records.  No  difficulty  arises  in  the  treatment  of 
partnership  proprietary  accounts  because  of  the  absence  of  a 
par  value  for  proprietorship ;  and  none  need  arise  in  the  case  of 
capital  stock.  In  fact  a  number  of  concerns  have  recently  or- 
ganized whose  stock  issues  have  no  stated  par  values. 

It  is  universal  practice  to  enter  capital  stock  in  the  accounts 
at  par,  when  a  par  value  is  stated.  The  Capital  Stock  account, 
therefore,  shows  only  a  certain  formal  amount.  If  the  stock  is 
sold  either  below  or  above  par  it  is  then  necessary  to  make  use 
of  the  subsidiary  accounts,  Discount  on  Stock  or  Premium  on 
Stock,  as  the  case  may  be,  to  show  the  difference  between  par 
and  actual  investment.  The  nature  and  treatment  of  such 
accounts  will  be  further  discussed  in  the  next  chapter. 
t  In  some  cases  the  stock  of  a  corporation  is  underwritten  by 
an  investment  or  brokerage  house.  This  usually  amounts  to 
the  sale  of  the  stock  for  the  corporation  on  a  commission  basis. 
In  such  a  case  the  contractual  relations  represented  by  such 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     283 

accounts  as  Subscriptions  and  Stock  Subscribed  may  exist 
directly  between  the  issuing  corporation  and  the  underwriters. 
The  opening  entries  in  this  event  may  differ  somewhat  in  form 
from  the  case  in  which  the  corporation  itself  sells  the  stock  to 
the  individual  investors  ;  but  the  final  result  is  the  same  in  either 
case. 

There  is  no  particular  advantage  to  be  gained  from  opening 
accounts  with  unissued  stock  and  capital  stock  authorized.  This 
information  is  contained  in  such  records  as  the  minutes  of  the 
directors'  meetings ;  or  it  usually  may  be  found  in  the  articles 
of  incorporation  and  in  the  stock  certificates.  It  is  sufficient 
for  practical  purposes  if  the  first  entries  in  the  books  proper  are 
made  when  subscriptions  are  actually  received,  and  cover  only 
the  amount  of  stock  actually  subscribed.  In  fact  erroneous 
conclusions  are  likely  to  be  drawn  by  the  stockholders  and  others 
if  such  accounts  as  Unissued  Stock  and  Capital  Stock  Authorized 
are  opened.  This  may  be  best  shown  by  first  giving  illustrative 
entries  involving  these  accounts. 

In  the  case  of  the  organization  of  the  Blank  Company  (refer- 
ring to  the  above  illustration),  for  example,  entries  might  have 
been  made  before  subscriptions  were  taken  as  follows : 

Unissued  Stock  (Common)      ....     $100,000 
Unissued  Stock  (Preferred)      ....        75,ooo 
Capital  Stock  Authorized 

(Common)  .     .     .  $100,000 

Capital  Stock  Authorized 

(Preferred) 75>°oo 

It  is  important  to  note  that  such  entries  represent  no  asset  or 
equity  facts.  Unissued  stock  is  not  an  asset.  It  represents 
simply  a  decision  of  the  incorporators ;  and  it  may  never  be 
issued.  Similarly  capital  stock  authorized  is  only  another  ex- 
pression for  unissued  stock  and  is  not  in  any  sense  an  equity. 
In  fact  the  left-hand  accounts  involved  in  the  above  entries  are 
simply  offsets  to  the  right-hand  accounts,  and  vice  versa.  There- 
fore no  corporate  balance  sheet  could  be  prepared  at  this  point. 
There  are  various  ways  of  making  the  later  entries  when  the 
above  fictitious  accounts  are  opened.  Subscriptions  may  be 
charged  and  Stock  Subscribed  credited  as  was  shown  before. 


284  PRINCIPLES  OF  ACCOUNTING 

When  the  subscribers  pay  their  subscriptions  and  the  stock  is 
issued  the  entries  may  be  as  follows : 

d) 

Cash $7S.ooo 

Subscriptions  (Common)    .     .     .  $50,000 

Subscriptions  (Preferred)    .    .     .  25,000 

and, 

(2) 

Stock  Subscribed  (Common) $50,000 

Stock  Subscribed  (Preferred) 25,000 

Unissued  Stock  (Common)    .    .    .  $50,000 

Unissued  Stock  (Preferred)    .    .    .  25,000 

The  resulting  balance  sheet  (before  the  balance  of  the  stock  is 
sold)  would  now  appear  as  follows : 

Cash $75,000  Capital  Stock  Authorized  $100,000 

Unissued  Stock  (Common)       50,000                 (Common) 
Unissued  Stock  (Preferred)      50,000  Capital  Stock  Authorized  75iOoo 
(Preferred)                

$175,000  $175,000 


An  item  of  unissued  stock  may  never  be  sold.  Many  corpora- 
tions at  the  time  of  organization  authorize  stock  far  in  excess  of 
the  amount  ever  issued.  In  case  further  issues  are  necessary 
it  is  convenient  to  have  such  an  authorization  available  so  that 
no  change  in  the  formal  capitalization  (which  may  necessitate 
a  revision  of  the  corporate  charter)  is  required.  Unissued  stock, 
if  carried  on  the  balance  sheet  in  such  a  case,  is  simply  a  valua- 
tion item  —  a  deduction  from  the  authorized  capital  stock  ap- 
pearing on  the  other  side.  Valuation  items  of  this  type  — 
which  serve  no  purpose  whatever  —  should  not  appear  in  the 
accounts.  They  are  often  confused  with  the  asset  items;  and 
in  any  case  they  serve  to  inflate  totals  and  consequently  lead  to 
erroneous  general  impressions.  A  great  many  companies  always 
show  stock  outstanding  on  the  balance  sheet  rather  than  stock 
authorized  ;  and  this  is  a  commendable  practice.  If  the  author- 
ized stock  is  shown  the  balance  sheet  might  well  be  prepared  in 
the  following  form : 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     285 

Sundry  Assets   ....    $500,000      Capital  Stock 

Authorized     $600,000 
Less  Unissued 

Stock     .    .      100,000 

$500,000 

$500,000  $500,000 


If  shown  as  a  deduction  in  this  way  there  is  less  objection  to  the 
recognition  of  unissued  stock. 


DONATED  AND  TREASURY   STOCK 

Capital  Stock  may  be  issued  for  property  other  than  cash. 
This  type  of  transaction  arises  very  commonly  in  connection 
with  reorganizations  and  mergers,  and  the  taking  over  of  partner- 
ships. The  original  promoters  and  incorporators  also  often  turn 
over  services  and  other  valuable  considerations  to  the  corpora- 
tion in  exchange  for  stock.  The  owner  of  a  patent  right,  for 
example,  may  be  instrumental  in  organizing  a  corporation  for 
the  purpose  of  exploiting  the  patent,  and  he  may  receive  a  large 
block  of  stock  as  a  payment  for  relinquishing  his  patent  privileges 
to  the  corporation.  Similarly  the  owner  of  a  mineral  tract,  or 
other  natural  resource,  may  find  it  necessary  to  take  an  equity 
in  a  corporation  in  exchange  for  his  property  in  order  that  the 
mine  or  other  asset  may  be  properly  developed.  In  some  of  these 
cases  interesting  and  complex  situations  arise.  In  particular 
the  treatment  of  "donated"  and  " treasury"  stock  raises  some 
questions  of  importance. 

A  modification  of  the  illustration  discussed  in  the  preceding 
section  will  serve  to  suggest  the  nature  of  these  questions.  Mr. 
Blank,  it  will  be  assumed,  who  is  a  prominent  figure  in  the  organ- 
ization of  the  Blank  Company,  has  subscribed  for  common 
stock  to  the  amount  of  $75,000  and  preferred  stock  to  the  amount 
of  $25,000.  He  agrees  to  pay  for  his  stock  by  turning  over  to 
the  company  a  factory  which  he  owns.  It  is  further  agreed  that 
he  is  to  donate  back  to  the  company  common  stock  to  the  amount 
of  $50,000  which  is  to  be  sold  to  provide  working  capital.  The 
securing  of  working  capital  is  a  matter  of  necessity.  A  corpo- 


286  PRINCIPLES  OF  ACCOUNTING 

ration,  obviously,  cannot  operate  without  having  a  fund  avail- 
able to  invest  in  working  and  trading  assets.  The  advantage 
of  donated  stock  lies  in  the  fact  that  such  stock  may  be  con- 
veniently sold  on  the  market  to  provide  the  necessary  current 
funds. 

But,  it  may  be  asked,  why  does  not  the  corporation  sell  the 
original  stock  to  outsiders  in  the  first  place?  The  purpose  of 
such  an  arrangement  as  the  above  is  to  make  possible  the  use  of 
the  phrase  "fully  paid  and  non-assessable"  on  the  stock  cer- 
tificates. A  stockholder,  as  was  stated  in  a  preceding  section, 
is  usually  liable  for  the  par  value  of  his  stock.  If  the  amount 
paid  in  at  the  time  the  stock  is  originally  issued  is  less  than  par, 
any  subsequent  holder  of  the  stock,  no  matter  at  what  price  he 
makes  his  purchase,  may  be  called  upon  by  the  corporation  at 
any  time  to  make  good  the  difference.  In  other  words,  he  may 
be  required  to  pay  an  assessment  or  assessments  equal  to  the 
difference  between  the  original  issuing  price  and  par.  Further, 
in  case  the  corporation  becomes  insolvent  the  holder  of  "partly- 
paid"  shares  is  usually  liable  to  the  creditors  for  the  unpaid 
balance.  Thus  non-assessable  stocks  can  be  sold  more  readily 
to  the  investing  public  than  the  assessable  issues.  It  is  considered 
in  the  case  of  donated  stock  that  the  stock  is  first  issued  at  par 
for  property.  Any  stock  donated  to  the  corporation  may  then 
be  "resold"  at  the  market  price  to  secure  working  capital.  In 
those  states  where  statutes  prohibit  the  issue  of  capital  stock  at 
less  than  par  stocks  are  also  often  issued  for  property  with  the 
understanding  that  a  part  of  the  stock  issued  is  to  be  returned 
to  the  corporation.  The  purpose  of  such  arrangements,  again, 
is  to  make  the  stock  fully  paid  in  order  to  facilitate  the  raising 
of  additional  capital.  In  most  cases  the  law  can  be  complied 
with  by  such  a  formal  transaction  as  the  one  mentioned 
above. 

At  the  time  Mr.  Blank  actually  turns  over  his  factory  to  the 
Blank  Company  and  receives  stock  in  payment  the  entries  would 
be  as  follows : 

(0 

Factory $100,000 

Subscriptions  (Common)      .     .     .  $75,000 

Subscriptions  (Preferred)      .     .     .  25,000 


CORPORATE  PROPRIETORSHIP  —  CAPITAL  STOCK     287 

and, 

(2) 

Stock  Subscribed  (Common)      ....       $75,000 
Stock  Subscribed  (Preferred)      ....         25,000 

Capital  Stock  (Common)      .     .     .  $75,000 

Capital  Stock  (Preferred)     .     .     .  25,000 

When  Mr.  Blank  donates  the  stock  to  the  corporation  the  journal 
entries  would  be : 

Donated  Stock  (Common) $50,000 

Reserve  for  Donated  Stock       .     .  $50,000 

The  account  Treasury  Stock  -might  be  used  here  instead  of 
Donated  Stock.  The  term  treasury  stock,  however,  may  well  be 
restricted  to  stock  once  issued  for  value  received  and  actually 
bought  back  by  the  corporation  on  a  cash  or  an  equivalent 
basis. 

The  exact  nature  of  the  accounts  involved  in  the  last  pair  of 
entries  given  depends  upon  the  actual  value  of  the  factory  turned 
over  to  the  corporation.  If  Blank  is  willing  to  return  to  the  cor- 
poration stock  with  a  par  value  of  $50,000  it  would  seem  reason- 
able to  conclude  that  the  factory  is  not  worth  more  than  $50,000. 
If  such  is  the  case  Donated  Stock  is  a  valuation  account  of  the 
nature  of  Unissued  Stock,  and  Reserve  for  Donated  Stock  is 
another  valuation  account  —  an  offset  to  the  value  of  the  fac- 
tory. A  conclusion  on  such  a  question  should  be  conditioned 
by  the  special  circumstances  involved  in  each  case. 

The  donated  stock  is  now  sold  for  cash  at  $75  per  share.  The 
entries  (in  summary  form)  would  be  : 

Cash $37,Soo 

Discount  on  Donated  Stock 12,500 

Donated  Stock $50,000 

If  the  factory  is  worth  but  $50,000,  the  balance  of  Reserve  for 
Donated  Stock  should  be  written  off  against  the  Factory  account. 
The  entries  would  be  as  follows : 

Reserve  for  Donated  Stock $50,000 

Factory $50,000 


288  PRINCIPLES  OF  ACCOUNTING 

A  balance  sheet  of  the  corporation  covering  these  transactions 
would  now  show  the  following  condition  : 

Factory    ......      $50,000  Capital  Stock  (Common)       $75,000 

Discount  on  Donated  Capital  Stock  (Preferred)        25,000 
Stock      ....        12,500 

Cash    .......        37,500  _ 

$100,000  $100,000 

Since  the  outstanding  common  stock  is  worth  apparently  but  $75 
per  share,  or  $56,250,  the  outstanding  preferred  stock  evidently 
has  a  value  of  $87,500  (the  total  value  of  the  assets)  less  $56,250, 
or  $31,250  —  a  value  of  $125  per  share. 

If  it  be  assumed  that  the  factory  is  really  worth  $100,000,  and 
that  Mr.  Blank  is  willing  to  make  this  arrangement  because  .of 
his  interest  in  the  success  of  the  enterprise,  this  virtually  means 
that  he  pays  a  premium  of  $50,000  for  his  stock.  This  assump- 
tion would  modify  the  above  entries.  Instead  of  using  the  ac- 
count Reserve  for  Donated  Stock,  it  would  be  proper  to  use 
Donated  Surplus.  The  factory  would  be  allowed  to  remain  at 
$100,000.  The  balance  of  Discount  on  Donated  Stock  would 
be  closed  against  Donated  Surplus.  The  resulting  balance  sheet 
would  be: 

Factory    ......     $100,000      Capital  Stock  (Common)       $75,000 

Cash    .......        37,5oo      Capital  Stock  (Preferred)        25,000 

Donated  Surplus    .     .     .        37,500 

$137,500 


In  such  a  case  the  donated  stock  would,  of  course,  be  likely  to 
sell  at  a  higher  price. 

In  this  connection  might  be  considered  the  significance  of 
treasury  stock  which  arises  from  purchases  by  the  corporation 
of  its  own  stock  for  cash  or  an  equivalent.  Quite  commonly 
accountants  consider  such  stock  as  an  asset  of  the  corporation, 
making  a  sharp  distinction  between  unissued  and  treasury  stock. 
As  a  matter  of  fact  there  is  only  a  superficial  distinction  between 
authorized  but  unissued  stock  and  stock  which  has  been  repur- 
chased by  (or  donated  to)  the  issuing  corporation.  Treasury 
stock  is  never  a  bona  fide  asset.  The  contrary  opinion  arises 
from  a  too  rigid  insistence  upon  the  corporate  entity.  This  can 


CORPORATE  PROPRIETORSHIP  —  CAPITAL  STOCK     289 

be  made  clear  by  a  consideration  of  illustrative  journal  entries 
and  balance  sheets.  Suppose  the  balance  sheet  of  a  certain 
corporation  appears  as  follows : 

Sundry  Assets        .     .     .    $200,000      Capital  Stock    ....    $300,000 

Cash 100,000 

$300,000  $300,000 

The  directors  now  decide  to  retire  a  portion  of  the  capital  stock 
by  buying  it  on  the  open  market.  The  reasons  for  such  a  decision 
are  various.  Conditions  may  be  favorable  to  a  curtailment  of 
the  activities  of  the  corporation  and  hence  the  available  cash 
may  well  be  returned  to  the  stockholders.  Such  transactions 
also  frequently  occur  when  to  attain  certain  purposes  the  "in- 
siders" wish  to  intrench  themselves  more  firmly  in  the  control 
of  the  company.  Whatever  the  reason  for  the  transaction,  the 
effect  upon  the  balance  she^t  is  essentially  the  same  in  every 
case.  The  directors  in  this  case,  it  will  be  assumed,  buy  750 
shares  on  the  open  market  at  par  ($100).  The  journal  entries 
(in  summary  form)  would  be : 

Treasury  Stock $75,000 

Cash $75,000 

The  resulting  balance  sheet  would  appear  as  follows  : 

Sundry  Assets   ....     $200,000      Capital  Stock    ....     $300,000 

Cash 25,000 

Treasury  Stock      .     .     .        75,ooo 

$300,000  $300,000 

Should  this  transaction  be  viewed  as  an  exchange  of  assets  or 
as  a  retirement  of  capital  with  an  equal  reduction  in  equities? 
The  latter  view  would  certainly  seem  to  be  the  correct  one  from 
the  accounting  standpoint.  A  corporation  cannot  maintain  its 
assets  by  buying  its  own  stock  from  its  own  members.  Treasury 
stock  cancelled  or  not  is  essentially  the  same  as  unissued  stock, 
—  a  deduction  from  the  apparent  outstanding  capital  stock. 
(Treasury  stock  can,  of  course,  be  issued  below  par  labelled  fully 
paid  and  non-assessable.)  It  is  no  more  an  asset  than  bank  notes 
in  the  hands  of  the  issuing  bank.  Indeed  in  the  above  entries 


2go  PRINCIPLES  OF  ACCOUNTING 

the  charge  might  well  have  been  made  to  Capital  Stock  instead 
of  to  Treasury  Stock,  in  which  case  treasury  stock  would  not 
appear  on  the  balance  sheet  at  all  and  outstanding  capital  stock 
would  appear  at  $225,000,  the  correct  figure.  If  it  is  desired  to 
reissue  the  stock  later  on  the  same  or  another  basis  this  can  be 
conveniently  done  without  recognizing  treasury  stock  in  the 
accounts.  In  any  case  it  will  be  necessary  to  cancel  the  old  cer- 
tificates and  issue  new.  It  may  be  that  stock  once  issued  can 
be  resold  to  greater  advantage  than  stock  authorized  but  not 
previously  issued.  This  fact,  however,  would  not  at  all  justify 
the  recognition  of  treasury  stock  as  an  asset.  If  treasury  stock 
appears  on  the  balance  sheet  it  should  be  viewed  as  unissued 
stock,  and  might  well  be  listed  as  a  deduction  from  capital  stock 
in  the  manner  illustrated  in  the  preceding  section. 

The  recognition  of  treasury  stock  as  an  asset  is  a  fiction  similar 
to  certain  partnership  transactions  discussed  in  the  preceding 
chapter.  The  accountant  must  at  certain  points  brush  aside 
the  fiction  of  the  business  enterprise  in  order  to  get  at  the  realities 
of  the  case.  Obviously  if  a  corporation  purchased  all  of  its  capital 
stock,  and  paid  a  price  based  upon  the  actual  value  of  the  assets, 
the  equity  of  the  stockholders  would  be  completely  retired. 
(Such  a  situation  would,  of  course,  usually  be  impossible  or  il- 
legal.) 

SUBSIDIARY   PROPRIETARY   RECORDS 

Thus  far  in  discussing  the  transactions  affecting  corporate 
proprietary  accounts  only  the  general  ledger  accounts  have  been 
shown.  There  has  been  no  description  of  the  records  which  take 
care  of  the  relations  between  the  individual  subscribers  and  stock- 
holders, and  the  corporation.  Where  proprietorship  is  vested 
in  a  numerous  and  shifting  personnel,  however,  it  is  evident  that 
the  keeping  of  records  which  show  the  status  of  each  individual 
owner  is  an  important  and  complex  task.  The  usual  subsidiary 
proprietary  books  and  transactions  involved  in  the  case  of  the 
corporation  will  be  briefly  discussed  in  this  section. 

When  a  corporation  is  organized  a  subscription  ledger  is  opened 
in  which  are  recorded  the  details  in  connection  with  each  sub- 
scription. The  general  ledger  account  "Subscriptions"  controls 
this  subsidiary  ledger.  (If  the  corporation  is  small,  and  the  in- 


CORPORATE   PROPRIETORSHIP  —  CAPITAL   STOCK     291 

dividual  subscribers  few  in  number,  each  subscriber's  account 
might  be  carried  in  the  general  ledger  and  the  subscription 
ledger  dispensed  with.)  When  Subscriptions  is  charged  each 
subscriber's  account  involved  in  the  subscription  ledger  is  also 
debited  with  the  proper  amount.  When  subscriptions  are  paid 
the  controlling  account  is  credited  and  the  proper  individual 
accounts  as  well.  The  balance  of  the  controlling  account  at  any 
time  shows  the  amount  still  due  the  corporation  on  all  its  sub- 
scription contracts,  and  the  individual  subscribers'  accounts  show 
how  this  amount  is  divided  among  the  various  subscribers.  In 
some  cases  where  the  subscriptions  are  to  be  paid  in  installments 
a  separate  installment  book  is  used  and  the  controlling  account, 
Subscriptions,  is  divided  into  several  accounts  corresponding  to 
the  number  of  installments. 

A  subscription. is  a  legal  claim  of  the  nature  of  a  promissory 
note,  and  if  the  subscriber  fails  to  meet  the  regular  calls  for  pay- 
ment he  may  be  sued  by  the  corporation.  If  payment  is  de- 
faulted and  the  amount  is  found  to  be  uncollectible  it  is  neces- 
sary to  reverse  the  original  entries  by  debiting  Stock  Subscribed 
and  crediting  Subscriptions  for  the  amount  involved.  The  de- 
faulting subscriber's  account  should  also  be  credited.  In  some 
cases  the  subscription  contract  contains  a  provision  to  the  effect 
that  any  sums  paid  on  the  subscription  will  be  forfeited  to  the 
corporation  provided  the  subscriber  fails  to  meet  InVobligations. 
The  amount  realized  in  such  a  case  is  a  kind  of  gain  and  may  be 
credited  to  Capital  Surplus.  (See  Chapter  XIII.)  There  may 
be  statutes,  however,  which  invalidate  such  contracts,  and  re- 
quire the  reimbursement  of  the  subscriber  for  the  amount  he  has 
invested. 

The  stock  ledger  is  a  subsidiary  book  containing  an  account 
with  each  stockholder  which  shows  the  par  value  of  the  stock 
owned  by  him  and  other  details.  The  stockholder's  individual 
account  is  credited  with  the  par  value  of  stock  purchased  by  or 
issued  to  him,  and  is  debited  with  the  par  value  of  any  stock 
which  is  ordered  transferred  to  other  parties.  Capital  Stock 
(outstanding)  is  the  controlling  account  for  this  ledger.  When 
Capital  Stock  is  credited  the  special  stockholders'  accounts  are 
also  credited  with  the  proper  amounts.  The  balance  of  each 
individual  account  shows  the  par  value  of  the  stock  then  owned 


PRINCIPLES  OF  ACCOUNTING 


by  the  stockholder ;  and  the  total  of  all  balances  in  the  stock 
ledger  should  agree  with  the  balance  of  the  Capital  Stock  account 
appearing  in  the  general  ledger. 

In  form  the  individual  stockholder's  account  appears  somewhat 
as  follows: 

J.  B.  HAWLEY, 

Birmingham,  Michigan 


DATE 

CERT. 

No. 

No. 

SHARES 

NAMES  AND  OTHER  DETAILS 

Da. 

CR. 

1918 

Aug.    3 

127 

IOO 

Subscribed  and  Paid 

S.J.    8 

2,500 

15 

47 

IO 

Transferred  from  A.  R. 

Watson 

SJ.I3 

250 

30 

105 

40 

Transferred   to  W.    S. 

Bailey 

S.  J.  20 

I,OOO 

Balance 

1,750 

2,750 

2,750 

Sept.    i 

214 

70 

Balance  (New 

Certificate) 

1,750 

Shares  of  stock,  like  other  kinds  of  personal  property,  may  be 
disposed  of  without  restriction,  at  the  pleasure  of  the  lawful 
owner.  "Active"  stocks  are  bought  and  sold  freely  on  the  stock 
exchanges  and  the  keeping  of  the  record  of  the  individual  stock- 
holders is  a  task  of  some  magnitude.  In  many  cases  large  cor- 
porations whose  stocks  are  frequently  dealt  in  on  the  market 
employ  a  transfer  agent  to  make  all  transfers  and  keep  the  sub- 
sidiary books.  For  dividend  and  other  purposes  the  current 
list  of  stockholders  is  then  secured  from  the  books  kept  by  the 
transfer  company.  Since  the  total  of  outstanding  stock  is  not 
affected  by  transfers  from  one  person  to  another,  the  controlling 
account,  Capital  Stock,  is  an  inactive  account,  showing  few 
changes  through  a  period  of  years. 

In  some  cases  stocks  are  assigned  from  person  to  person  and 
the  transfers  are  not  registered  on  the  books  of  the  company. 
The  records  of  the  corporation,  in  other  words,  may  not  show  an 
up  to  date  list  of  the  actual  stockholders.  The  corporation, 
however,  recognizes  as  voting  shareholders  the  list  from  its  own 
records,  and  makes  up  its  dividend  schedules  from  the  roll  of 
stockholders  as  it  appears  in  its  stock  ledger. 


CORPORATE  PROPRIETORSHIP  —  CAPITAL   STOCK     293 

The  stock  certificate  book  contains  blank  stock  certificates  and 
stubs.  When  a  certificate  is  issued  the  data  written  in  the  stock 
certificate  is  also  entered  on  the  stub.  Postings  to  the  stock 
ledger  may  be  made  from  these  stubs,  but  where  the  transfers 
are  numerous  it  is  desirable  to  make  use  of  a  special  stock  journal. 
Cancelled  certificates  are  sometimes  attached  to  the  appropriate 
stubs  and  kept  as  a  permanent  record. 

There  are  many  other  cases  of  corporate  proprietary  trans- 
actions than  those  discussed  in  this  chapter.  The  conversion  of 
securities  from  one  type  to  another  and  the  retirement  of  serial 
stocks  have  already  been  referred  to.  Increases  and  decreases 
of  capital  stock  in  connection  with  mergers,  business  expansion, 
dissolution,  etc.,  are  of  common  occurrence  under  modern  finan- 
cial conditions.  Such  transactions  are  often  very  complex  but 
no  important  general  peculiarities  in  accounting  for  capital  stock 
not  already  discussed  arise  in  such  cases.  The  corporate  surplus 
and  related  accounts  will  be  discussed  in  the  next  chapter. 


XIII 

CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS 

IT  has  been  stated  that  proprietorship  in  the  case  of  the  cor- 
poration is  represented  by  the  capital  stock  and  surplus  or  deficit 
accounts.  In  the  broadest  sense,  therefore,  surplus  represents 
the  excess  of  actual  proprietorship  in  a  given  case  over  the  par 
value  of  the  capital  stock  outstanding,  and  deficit  —  or  negative 
surplus  —  represents  the  amount  by  which  the  par  of  the  capital 
stock  exceeds  proprietorship.  In  accounting  practice,  however, 
surplus  so  defined  may  appear  under  a  number  of  special  heads. 
The  accounts  representing  surplus  and  deficit  form  an  important 
%roup  of  corporate  accounts ;  and  the  numerous  transactions 
affecting  these  accounts  often  involve  difficult  questions  of  an- 
alysis. Probably  no  other  accounting  concept  is  so  commonly 
misunderstood  as  that  of  the  surplus,  and  consequently  the  sur- 
plus accounts  are  very  frequently  misinterpreted.  This  makes 
the  study  of  these  accounts  a  matter  of  considerable  importance. 
In  this  chapter  the  typical  surplus  accounts  will  be  discussed 
and  the  important  types  of  transactions  affecting  these  accounts 
will  be  illustrated.  A  sharp  distinction  will  be  drawn  at  the 
outset  between  the  two  main  types  of  surplus  (and  deficit) : 
(i)  that  which  originates  at  the  time  of  organization  and  in  con- 
nection with  any  subsequent  sale  of  securities ;  and  (2)  accumu- 
lated profit  or  loss  resulting  from  business  operation  and  the 
accidents  of  the  industrial  situation. 

CAPITAL   SURPLUS   AND   DEFICIT 

Very  frequently  when  a  corporation  is  organized  the  par  value 
of  the  stocks  issued  exceeds  the  value  of  all  the  property  acquired. 
This  simply  means  that  securities  such  as  stocks  are  usually  sold 
for  the  first  time  at  a  discount.  It  is  common  practice  to  write 

294 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  295 

up  the  property  to  the  point  at  which  securities  are  apparently 
validated.  This  is  sometimes  done  by  using  "real  estate, 
patents,  machinery,  etc. "  —  or  some  similar  caption  —  on  the 
balance  sheet.  This  practice  is  decidedly  illegitimate.  If 
goodwill  or  other  intangibles  are  involved  in  any  case  it  is  proper 
to  put  these  items  on  the  books,  but  they  should  be  isolated  in 
the  balance  sheet  and  should  be  listed  at  the  actual  amounts 
carried  in  the  appropriate  accounts.  The  use  of  general  balance 
sheet  captions,  and  the  indiscriminate  writing  up  of  property 
to  make  an  apparent  validation  of  securities  issued,  should  be 
avoided.  The  item  discount  on  stock  should  appear  frankly  on 
the  balance  sheet  as  an  offset  to  stocks  entered  at  par  but  issued 
at  a  discount.  Both  Discount  on  Stock  and  Deficit  are  offset 
or  valuation  proprietorship  accounts.  It  is  desirable,  however, 
to  distinguish  between  the  two,  and  to  restrict  the  use  of  Discount 
on  Stock  to  cases  where  the  par  value  of  the  stock  at  the  time  of 
issue  exceeds  the  value  of  the  assets  acquired  by  the  corporation 
in  exchange.  The  Deficit  account  may  then  be  used  to  indicate 
an  offset  to  original  proprietorship  caused  by  losses  in  business 
operation. 

A  capital  surplus  at  the  time  of  organization  is  of  comparatively 
rare  occurrence  in  the  case  of  American  corporations.  One  pos- 
sibility, the  donated  surplus,  has  already  been  discussed,  but 
the  most  important  case  of  capital  surplus  arises  in  connection 
with  the  sale  of  stocks  at  a  premium.  The  excess  of  the  issuing 
or  selling  price  over  the  par  value  of  the  stock  is  premium.  The 
sale  of  stocks  at  a  premium  is  quite  common  in  those  states  which 
prohibit  the  issuance  of  stocks  at  a  discount  by  statute.  In 
many  such  cases,  however,  where  the  stock  is  issued  for  property 
other  than  cash,  the  premium  is  only  nominal  due  to  the  fact  that 
inflated  valuations  are  set  upon  the  properties  involved.  An- 
other important  illustration  of  stock  premium  occurs  in  connec- 
tion with  the  organization  of  banking  corporations.  Because 
of  the  actual  and  traditional  advantages  of  investments  in  such 
companies  their  stocks  are  often  issued  at  a  price  considerably 
above  par. 

Since  stocks  are  always  entered  in  the  capital  stock  accounts 
at  par  it  is  necessary  to  open  a  special  account  in  which  to  record 
the  amount  of  the  premium  in  any  case.  Suppose,  for  example, 


296  PRINCIPLES  OF  ACCOUNTING 

that  a  trust  company  issues  stock  with  a  par  value  of  $100,000 
at  $115  per  share.  The  journal  entries  (summarized)  would  be 
somewhat  as  follows : 

Cash $115,000 

Capital  Stock        $100,000 

Capital  Surplus 15,000 

Such  a  surplus  account  should  have  some  distinctive  title  such 
as  the  one  used  here.  In  railroad  accounting  the  Interstate 
Commerce  Commission  prescribes  the  use  of  the  accounts  Pre- 
mium on  Stock  and  Discount  on  Stock,  for  the  recording  of  capital 
surplus  and  deficit  respectively.  This  is  a  commendable  prac- 
tice. One  source  of  confusion  in  accounting  is  the  loose  and 
non-standardized  nomenclature.  The  names  of  accounts  should 
give  at  least  some  clue  to  what  they  contain  even  if  it  is  neces- 
sary to  use  rather  long  titles. 

The  later  treatment  of  stock  discounts  and  premiums  in  the 
accounts  is  a  matter  of  considerable  importance.  It  is  usually 
conceded  to  be  good  practice  to  charge  the  amount  of  stock  dis- 
count in  any  case  against  annual  or  accumulated  profits.  In  fact 
some  accountants  urge  that  proprietary  discounts  be  written  off 
as  rapidly  as  possible,  so  that  such  valuation  items  may  be 
removed  from  the  balance  sheet.  There  is  some  question  as  to 
the  propriety  of  such  a  procedure,  however,  for  if  capital  stock 
has  been  issued  at  a  discount  the  original  investment  is  less  than 
the  par  of  the  stock  and  the  two  accounts,  Capital  Stock  and 
Discount  on  Stock,  taken  together,  show  the  amount  of  original 
proprietorship.  The  Discount  on  Stock  account  is  therefore 
really  a  section  of  the  Capital  Stock  account.  It  would  seem 
desirable  to  use  one  group  of  proprietary  accounts  (the  capital 
stock  accounts)  to  show  investments,  and  another  group  (the 
accumulated  surplus  accounts)  to  reflect  the  amount  of  income 
retained  in  the  business.  If,  however,  discount  on  stock  is  ex- 
tinguished by  charges  against  net  revenue  or  surplus  the  amount 
of  the  original  investment  is  obscured,  and  the  amount  of  accumu- 
lated income  as  well.  It  is  perfectly  proper  to  allow  surplus  to 
accumulate,  but  it  is  advantageous  to  have  the  amount  of  such 
accumulation  segregated  in  the  accounts.  In  other  words,  since 
stock  discount  and  surplus  are  not  exact  opposites,  it  would  be  a 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS 


297 


rational  procedure  to  maintain  Discount  on  Stock  indefinitely 
on  the  books  even  though  a  Surplus  account  also  appears.  The 
amount  of  accumulated  corporate  surplus  is  an  important  fact 
in  connection  with  the  relations  of  the  public  to  the  enterprise, 
as  well  as  in  connection  with  the  relations  between  different 
classes  of  equities  within  the  enterprise.  Any  practice,  therefore, 
which  tends  to  disturb  the  integrity  of  the  accumulated  surplus 
figure,  is  questionable. 

Similarly  (as  is  generally  admitted),  Premium  on  Stock  may 
well  be  considered  as  a  permanent  account  —  a  section  of  the 
Capital  Stock  account.  The  two  accounts,  taken  together,  show 
again  the  amount  of  original  investment.  If  the  amount  of  the 
premium  in  any  case  is  credited  to  a  regular  surplus  or  net  rev- 
enue account  either  at  the  time  of  organization  or  later,  both 
surplus  and  investment  figures  are  obscured.  Further,  since 
dividends  are  often  appropriated  from  surplus,  the  amount  of 
stock  premium,  if  added  to  general  surplus,  might  appear  to  be 
available  for  dividend  purposes.  If  dividends  are  declared  from 
a  stock  premium,  this  simply  means  that  a  portion  of  the  stock- 
holders' original  capital  investment  is  being  returned.  While 
such  a  practice  might  not  be  considered  illegal,  it  would  usually 
be  an  unwise  policy ;  and  in  any  case  the  nature  of  the  trans- 
action should  be  clearly  recognized.  Premium  on  Stock,  then, 
should  remain  in  the  ledger  as  a  permanent  account,  until  such 
time  as  a  part  or  all  of  the  capital  stock  is  retired. 

ACCUMULATED   PROFIT   AND    LOSS 

As  was  emphasized  above  it  is  desirable  to  restrict  the  terms 
surplus  and  deficit  to  their  most  common  usage,  namely,  accumu- 
lated profit  and  loss.  If  a  "  surplus  "  account  is  used  to  represent 
any  other  fact,  qualifying  terms  should  be  added  to  the  account 
title  so  that  there  can  be  no  doubt  as  to  the  meaning  intended. 
Surplus,  then,  is  the  resultant  of  net  proprietary  income  balances 
which  have  not  been  distributed  as  dividends.  An  illustration 
will  serve  to  make  the  origin  of  surplus  in  the  accounts  entirely 
clear.  Suppose  that  the  Net  Revenue  account  of  a  certain  cor- 
poration shows  a  net  revenue  figure  of  $40,000  available  for 
partition  among  the  various  equities.  The  interest  accrued  on 


298  PRINCIPLES  OF  ACCOUNTING- 

outstanding  bonds,  it  will  be  assumed,  amounts  to  $10,000. 
The  directors  order  a  dividend  posted  of  $15,000,  and  allow  the 
balance  of  Net  Revenue  to  be  carried  to  Surplus.  The  entries 
giving  effect  to  this  situation  would  be  as  follows : 

d) 

Net  Revenue $10,000 

Interest  Payable $10,000 

(2) 

Net  Revenue $15,000 

Dividends  Payable $15,000 

(3) 

Net  Revenue $15,000 

Surplus $15,000 

Thus  it  is  evident  that  the  final  incidence  of  all  undistributed 
net  proprietary  income  is  in  the  Surplus  account.  Accumulated 
surplus,  in  other  words,  is  the  sum  of  the  annual  surpluses.  Ac- 
cumulated deficit,  on  the  other  hand,  represents  the  sum  of  all 
the  annual  deficits  (offset,  of  course,  by  any  surpluses).  A  pro- 
prietary deficit  may  arise  if  expenses  exceed  revenues,  if  net 
revenue  is  insufficient  to  meet  interest  and  tax  obligations,  or 
if  dividends  are  paid  in  excess  of  net  proprietary  income.  A 
deficit  in  the  last  case  simply  represents  the  deduction  from  orig- 
inal proprietorship  due  to  the  return  of  capital  to  the  stockholders 
and  on  the  balance  sheet  has  a  significance  somewhat  similar  to 
stock  discount. 

In  practice  an  intermediate  surplus  account,  Undivided  Profits, 
is  sometimes  used.  Such  an  account  receives  any  income  bal- 
ances which  are  not  to  be  withdrawn  at  the  end  of  the  current 
fiscal  period,  but  which  may  become  the  basis  of  dividends  in 
later  years.  Such  an  account  can  be  used  as  a  convenient  buffer 
to  stabilize  the  dividend  rate  without  necessitating  an  encroach- 
ment upon  capital.  A  stable  dividend  rate  is  a  great  convenience 
to  the  stockholders  who  are  depending  upon  their  dividends  to 
meet  current  personal  obligations.  A  fixed  rate  also  is  of  ad- 
vantage in  that  it  tends  to  promote  the  credit  and  general  finan- 
cial standing  of  the  corporation.  Since,  however,  net  revenue 
will  fluctuate  year  by  year  according  to  the  exigencies  of  the 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  299 

business  situation,  net  revenue  balances  cannot  be  followed  in 
declaring  dividends  if  a  constant  rate  is  to  be  established.  Ac- 
cordingly in  lean  years  the  Undivided  Profits  account  may  be 
drawn  upon,  and  in  boom  years  the  balance  of  Net  Revenue 
after  dividends  are  declared  may  be  transferred  to  Undivided 
Profits.  It  is  a  mistake  to  suppose  that  a  stable  dividend  rate 
depends  upon  a  constant  net  revenue  figure. 

When  an  Undivided  Profits  account  is  used  the  Surplus  account 
may  be  restricted  to  those  items  of  net  proprietary  income  which 
have  been  specifically  recognized  as  a  part  of  the  permanent  pro- 
prietorship. In  the  case  of  rapidly  expanding  enterprises  it 
may  be  necessary  to  use  the  earnings  to  buy  new  equipment, 
and  such  a  process,  of  course,  builds  up  a  surplus.  The  distinc- 
tion between  Undivided  Profits  and  Surplus  is  not,  however,  a 
matter  of  very  great  importance.  These  account  titles  may  be 
used  interchangeably  without  confusion ;  and  as  a  rule  it  is  not 
necessary  to  make  use  of  two  such  accounts  in  a  single  enterprise. 

A  surplus  account  might  be  used  in  the  case  of  a  single-pro- 
prietorship or  partnership  as  well  as  in  the  case  of  a  corporation. 
In  fact  the  individual  proprietor's  personal  or  drawing  account 
serves  much  the  same  purpose  as  the  Undivided  Profits  account. 
Since  there  is  no  par  value  for  proprietorship  in  these  cases, 
however,  it  is  customary  to  transfer  income  balances  directly 
to  the  main  proprietary  accounts.  Yet  this  process  obscures 
original  investment  and  accumulated  income  figures,  and  hence 
accounts  analogous  to  Surplus  might  well  be  used  in  all  enter- 
prises. 

Surplus  is  accumulated  for  various  purposes,  some  of  which 
have  already  been  suggested.  In  general  it  seems  to  be  desirable 
for  a  corporation  to  adopt  a  conservative  policy  in  regard  to 
dividend  distributions,  and  to  build  up  a  buffer  account  which 
will  serve  to  absorb,  in  a  measure,  the  shock  of  financial  strin- 
gency or  other  business  hardship  or  disaster.  The  individual 
stockholder  would  often  prefer  to  have  larger  dividends  paid ; 
but  the  accumulation  of  surplus,  within  reasonable  limits,  is 
usually  regarded  as  a  sound  financial  policy.  Unless  the  business 
in  any  case  may  be  conveniently  expanded,  however,  it  may  be 
unwise  to  withhold  any  large  amount  of  profit  from  the  stock- 
holders, for  this  would  require  the  investment  of  the  current 


300  PRINCIPLES  OF  ACCOUNTING 

assets  which  are  concurrently  accumulating  in  property  such  as 
securities  and  similar  assets.  This  would  mean  a  change  in  the 
character  of  the  stockholders'  investment,  and  hence  might  not 
be  in  accord  with  the  best  interests  of  the  shareholders. 

It  needs  to  be  emphasized  that  the  surplus  accounts  are  equity 
accounts.  The  term  surplus  is  often  used  in  business  practice 
in  the  sense  of  cash  and  other  liquid  funds  available.  In  ac- 
counting, however  Surplus  (or  any  of  its  subdivisions)  is  a  pro- 
prietary equity  account,  representing  as  already  explained  the 
excess  of  present  proprietorship  over  formal  capitalization  (less 
any  organization  discounts  if  used  as  advised  above),  and  not 
representing  any  specific  assets.  Surplus,  as  is  the  case  with 
any  equity  item,  is  balanced  by  assets  on  the  opposite  side  of 
the  balance  sheet;  but  no  specific  asset  can  be  tied  definitely 
to  this  or  any  other  equity.  The  only  inevitable  relation  between 
assets  and  equities  is  the  equality  of  totals.  Surplus,  then,  may 
be  considered  as  offset  among  the  assets  by  equipment,  cash, 
accounts  receivable,  materials  or  any  other  item. 

Turning  now  from  the  discussion  of  the  origin  and  general 
nature  of  surplus,  it  will  be  necessary  to  consider  the  principal 
subdivisions  of  surplus  and  the  process  of  setting  up  these  ac- 
counts. A  large  number  of  the  resolutions  of  the  board  of  direc- 
tors affect  the  surplus  accounts.  The  process  of  subdividing 
surplus  is  sometimes  spoken  of  as  the  making  of  "appropriations " 
from  surplus.  In  itself  it  is  a  purely  formal  process  and  can  go 
on  indefinitely  without  affecting  the  property  accounts.  Making 
appropriations  from  surplus  simply  means  the  putting  of  different 
labels  on  portions  of  surplus ;  and  this  process  should  never  be 
confused  with  the  setting  up  of  assets  in  special  funds.  These 
appropriations  may  express  the  financial  policies  and  intentions 
of  the  directors,  however,  and  in  this  way  indirectly  affect  the 
asset  accounts.  In  the  following  sections  typical  examples  of 
surplus  appropriations  will  be  considered. 

DIVIDEND   APPROPRIATIONS 

Dividends  are  frequently  appropriated  from  the  Surplus 
account.  A  dividend  in  ordinary  usage  is  a  distribution  to  the 
stockholder  of  net  proprietary  income.  As  already  explained, 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  301 

however,  the  term  " dividend"  is  sometimes  applied  to  distribu- 
tions which  contain  an  element  at  least  of  original  capital.  This 
is  particularly  true  in  the  case  of  wasting  asset  enterprises  such 
as  mining  companies.1  But  as  a  rule  dividends  are  appropriated 
and  paid  from  current  or  accumulated  profits ;  and  except  in 
special  circumstances  it  is  a  general  principle  of  corporation  law 
that  dividends  must  not  be  paid  out  of  capital.  As  stated  above, 
dividends  are  usually  assumed  to  be  profits ;  and  were  disburse- 
ments of  capital  made  under  this  guise  allowed  to  rank  as  profits 
the  stockholders  in  general  and  other  parties  interested  would  be 
misled,  and  certain  classes  of  stockholders  and  creditors  might 
be  defrauded. 

The  most  common  type  of  dividend  appropriation  (or  declara- 
tion) is  the  cash  dividend.  Such  a  dividend  may  be  appropriated 
from  the  Net  Revenue  (or  Profit  and  Loss  Allocation)  account, 
from  an  account  called  Undivided  Profits  as  explained  in  the 
preceding  section,  or  from  any  general  surplus  account.  If  a 
corporation  has  adopted  a  stable  dividend  policy  it  is  a  convenient 
accounting  procedure  to  transfer  all  proprietary  net  income 
from  Net  Revenue  to  Surplus,  and  to  make  all  dividend  appro- 
priations from  the  latter  account.  To  illustrate  this  procedure 
it  will  be  assumed  that  a  certain  corporation  has  a  proprietary 
income  after  interest  charges  are  met  of  $50,000.  The  entries 
transferring  this  balance  to  Surplus  would  be : 

Net  Revenue $50,000 

Surplus $50,000  . 

The  entries  covering  the  declaration  of  a  dividend  of  $25,000 
would  now  be  as  follows : 

Surplus $25,000 

Dividend  Payable $25,000 

These  last  entries  involve  a  withdrawal  of  $25,000  from  Sur- 
plus, and  the  setting  up  of  the  same  amount  in  a  special  account. 
In  a  sense  the  Dividend  Payable  account  represents  a  part  of 
the  general  surplus,  labeled  for  a  particular  purpose.  It  is  true 

1  It  is  noticeable  that  several  such  companies  have  recently  adopted  the  policy 
of  apportioning  disbursements  to  the  stockholders  between  actual  dividends  and 
capital  return. 


302  PRINCIPLES  OF  ACCOUNTING 

that  a  declared  dividend  must  be  paid  like  any  debt,  and  that  a 
stockholder  can  sue  the  corporation  for  the  amount  of  any  un- 
paid dividends  once  posted,  yet  it  seems  a  misnomer  to  call  such 
an  item  a  liability  in  the  accounting  sense.  It  represents  an 
equity  of  the  proprietors  and  hence  is  clearly  a  part  of  total 
proprietorship.  Until  the  dividend  is  paid  there  is  no  change  in 
total  assets  or  in  total  equities.  In  the  analysis  of  the  balance 
sheet  how  should  a  dividend  declaration  be  viewed  ?  Is  it  not 
simply  a  special  part  of  the  corporate  surplus?  At  any  rate 
a  dividend  payable  is  a  part  of  the  stockholders'  equity,  and 
since  the  stockholders  are  usually  considered  as  representing 
the  corporate  proprietors  there  is  some  reason  at  least  for  this 
view. 

At  the  time  the  above  dividend  is  paid  the  following  entries 
would  be  made : 

Dividends  Payable $25,000 

Cash       $25,000 

These  entries  represent  the  actual  payment  of  cash  and  an  equal 
deduction  from  the  stockholders'  equity.  The  preceding  entries 
represent  simply  transpositions  of  equity  items. 

In  some  cases  a  small  balance  may  appear  in  the  Dividends 
Payable  account  for  a  long  period.  It  is  not  always  possible  to 
locate  all  the  stockholders  in  the  case  of  a  corporation  with  a 
large  and  widely  scattered  membership.  A  small  part  of  a  divi- 
dend declaration  may,  therefore,  remain  unpaid  for  years,  but 
after  such  items  have  legally  lapsed  the  unpaid  balance  of  the 
Dividends  Payable  account  may  be  transferred  again  to  the  Sur- 
plus account. 

Various  names  are  applied  to  dividend  accounts.  Dividends 
Payable,  Dividends  Declared,  and  Dividends  Posted  are  common 
examples.  It  is  usually  advisable  to  number  each  dividend 
declaration,  and  the  account  may  be  labeled  correspondingly, 
as,  for  example,  Dividend  #i. 

When  a  dividend  is  declared  a  schedule  of  stockholders'  names 
must  be  prepared,  and  the  amount  of  dividend  due  each  stock- 
holder must  be  computed  and  entered  on  this  schedule.  Such  a 
schedule  virtually  amounts  to  an  accounts  payable  ledger.  Each 
individual  account  may  be  closed  when  a  check  for  the  proper 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUN.o   ._.. 

v/      O 

amount  is  mailed  to  the  shareholder.  All  matters  of  procedure 
involved  in  the  payment  of  dividends  are,  of  course,  the  same 
whether  the  dividend  be  appropriated  from  current  or  accumu- 
lated income. 

An  appropriation  and  distribution  of  proprietary  income  to 
the  members  of  a  partnership  may  also  be  called  a  dividend. 
Because  of  the  nature  of  the  partnership  as  previously  explained, 
however,  a  distribution  of  income  to  the  partners  is  not  as  formal 
or  important  a  transaction  as  a  dividend  appropriation  and  pay- 
ment in  the  case  of  a  corporation.  In  common  usage  the  ex- 
pression "dividend"  usually  has  reference  to  the  declarations 
of  corporations. 

Surplus  may  be  appropriated  as  "stock"  dividends.  If  there 
is  an  accumulated  surplus  a  dividend  may  be  declared  even  if 
there  is  insufficient  cash  available  to  pay  the  dividend.  If 
income  has  been  invested  in  equipment  and  merchandise  this 
does  not  affect  the  showing  of  net  revenue  or  the  amount  of 
accumulated  surplus.  The  actual  payment  of  a  dividend,  how- 
ever, requires  cash  or  an  equivalent.  Sometimes  cash  is  bor- 
rowed for  dividend  purposes  although  the  corporate  treasury  is 
temporarily  empty.  An  alternative  procedure  in  such  a  case  is 
the  issuance  of  either  "scrip"  or  stock  dividends.  A  scrip 
dividend  may  be  used  when  it  is  expected  that  cash  will  be  avail- 
able shortly  with  which  to  redeem  the  corporation's  formal 
promises  to  pay  which  have  been  issued  to  the  stockholders.  A 
stock  dividend  may  be  declared  if  it  be  decided  to  retain  the 
available  assets  indefinitely. 

A  great  deal  of  confusion  exists  in  popular  discussions  of  stock 
dividends.  A  stock  dividend  in  a  sense  is  no  dividend  at  all. 
The  payment  of  such  a  dividend  involves  no  withdrawal  of  cash 
or  other  assets.  It  is  purely  a  formal  process  as  far  as  the  balance 
sheet  totals  are  concerned.  The  directors  decide  to  issue  stock 
certificates  covering  a  part  or  all  of  the  accumulated  surplus. 
This  is  simply  a  formal  recognition  of  their  intention  to  allow  this 
surplus  to  remain  permanently  as  investment.  Once  represented 
by  stock  certificates  it  is  no  longer  available  for  other  appro- 
priations. A  stock  dividend  is  really  simply  a  portion  of  the 
surplus,  renamed.  This  is  clearly  shown  by  an  examination  of 
the  journal  entries.  Suppose  a  corporation,  with  an  unappro- 


PRINCIPLES  OF  ACCOUNTING 

priated  surplus  of  $75,000,  decides  to  issue  a  stock  dividend 
of  $50,000.  The  entries  would  be : 

Surplus $50,000 

Capital  Stock $50,000 

These  entries  transfer  a  credit  balance  of  $50,000  from  the  Sur- 
plus to  the  Capital  Stock  account.  (It  would  also  be  necessary 
to  credit  the  individual  stockholders'  accounts  at  this  time  with 
the  distribution  of  the  new  stock,  pro  rata.}  The  actual  ad- 
justment is  usually  made  by  calling  in  the  old  stock  certificates 
and  issuing  new  ones  for  a  proportionally  greater  number  of  shares 
in  each  case. 

The  action  of  the  stock  market  when  a  stock  dividend  is  dis- 
tributed (a  "melon-cutting")  is  somewhat  irrational.  Usually 
the  market  price  of  the  total  of  the  stockholders'  equity  advances 
after  such  a  distribution.  There  seems  to  be  little  real  founda- 
tion for  this  situation.  Total  proprietorship  is  neither  increased 
nor  decreased  by  the  payment  of  a  stock  dividend.  This  may 
be  made  clear  by  an  examination  of  the  balance  sheets  of  a  hy- 
pothetical company  before  and  after  the  distribution  of  such  a 
dividend.  The  balance  sheet  of  the  A  Company  (in  summary 
form)  appears  as  follows  : 

Sundry  Assets   ....    $500,000      Capital  Stock    ....  $300,000 

Surplus 100,000 

Liabilities 100,000 

$500,000  $500,000 


The  amount  of  proprietorship  as  shown  by  this  statement  is  evi- 
dently the  sum  of  the  capital  stock  and  surplus  items  or  $400,000. 
A  stock  dividend  of  $100,000  is  now  declared  and  distributed. 
The  balance  sheet  after  the  consummation  of  this  transaction 
would  appear  as  follows : 

Sundry  Assets        .     .     .    $500,000      Capital  Stock    ....    $400,000 

Liabilities 100,000 

$500,000  $500,000 

In  this  statement  proprietorship  still  stands  at  $400,000,  the 
balance  of  the  Capital  Stock  account.     The  Capital  Stock  and 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  305 

Surplus  accounts  have  been  combined.  Since  the  assets  are 
unchanged  and  total  proprietorship  is  the  same  as  before  there 
seems  to  be  no  valid  reason  for  an  advance  in  the  market  value 
of  the  total  capital  stock.  If  this  stock  has  a  par  of  $100  one 
would  naturally  expect  the  price  of  the  stock  before  the  new  issue 
was  made  to  be  about  $133  per  share,  and  after  the  stock  divi- 
dend is  issued  about  $100  per  share.  This  assumes,  of  course, 
that  the  balance  sheet  given  shows  the  actual  value  of  the  assets. 
It  is,  however,  a  familiar  fact  that  security  prices  do  not  always 
closely  conform  to  what  one  would  expect  in  view  of  the  informa- 
tion shown  by  the  accounts. 

The  issue  of  a  stock  dividend,  evidently,  obscures  the  amount 
of  accumulated  surplus  and  the  amount  of  original  investment. 
This  statement  suggests  a  common  reason  for  such  dividends. 
Corporations  which  are  making  huge  profits,  and  which  wish  to 
pay  but  an  ordinary  rate  of  dividends  on  formal  capitalization 
will  often  gradually  transfer  their  accumulated  earnings  from  the 
Surplus  to  the  Capital  Stock  account.  It  is  then  possible  to 
declare  much  larger  aggregate  cash  dividends  at  the  same  normal 
rate  on  formal  capital.  In  connection  with  public  utilities  this 
practice  may  also  be  made  the  basis  of  an  argument  for  the  main- 
tenance of  rates.  A  corporation,  it  is  urged,  should  be  allowed 
a  fair  rate  on  its  outstanding  securities.  Evidently  such  an  ac- 
counting practice  gives  the  corporation  an  opportunity  to  beg 
the  real  question  as  to  what  rate  per  cent  is  being  earned,  or 
should  be  allowed,  on  actual  investment. 

Corporate  surplus  is  a  red  flag  to  certain  rather  noisy  elements 
in  public  opinion.  Undoubtedly  this  has  something  to  do  with 
the  practice  of  issuing  stock  dividends  in  certain  lines  of  industry. 
These  dividends  "  cover  up  "  surplus.  This  is  hardly  a  sufficient 
basis,  however,  for  a  general  condemnation  of  the  practice  in 
the  case  of  the  ordinary  competitive  enterprise. 

SINKING   FUND   APPROPRIATIONS 

An  important  illustration  of  a  type  of  surplus  account  arises 
in  connection  with  the  setting  up  of  sinking  funds  for  special 
purposes.  A  sinking  fund  is  simply  a  special  fund  of  assets 
(usually  liquid)  which  is  created  in  anticipation  of  some  event 


306  PRINCIPLES  OF  ACCOUNTING 

such  as  the  replacement  of  an  important  unit  of  the  plant  or  the 
maturity  of  a  large  obligation  or  equity.  Suppose,  for  example, 
that  the  bond  contract  in  the  case  of  a  corporation  having  out- 
standing $1,000,000  of  twenty-year  bonds  requires  that  each 
year  until  the  bonds  mature  liquid  assets  to  the  amount  of  $50,000 
must  be  set  aside  in  the  hands  of  a  trustee.  (The  directors 
might,  of  course,  decide  to  adopt  the  sinking  fund  method  of 
their  own  volition.  This  illustration  ignores  interest.  Sinking 
fund  calculations  and  entries  will  be  fully  explained  in  Chapter 
XVIII.)  The  entries  recognizing  this  requirement  each  year 
would  be : 

.    Sinking  Fund  Assets        $50,000 

Cash        $50,000 

These  entries  involve  simply  a  transposition  of  assets  and  do 
not  affect  any  of  the  equity  accounts.  But  suppose,  further, 
that  the  bond  contract  requires  an  appropriation  of  $50,000 
each  year  from  net  income  or  surplus  under  the  title  of  "sinking 
fund  reserve."  (Various  terms  such  as  "reserve  for  sinking 
fund,"  "sinking  fund"  or  "sinking  fund  surplus,"  may  be  ap- 
plied to  this  appropriation.)  The  reason  for  such  a  requirement 
is  that  the  bondholder  is  better  protected  if  profits  are  being  re- 
tained in  the  business.  The  entries  setting  up  such  a  surplus 
should  be  carefully  considered.  The  appropriation  might  be 
made  directly  from  Net  Revenue.  In  this  case  the  entries  would 
be: 

Net  Revenue $50,000 

Sinking  Fund  Reserve $50,000 

The  balance  of  Net  Revenue  ($75,000,  it  may  be  assumed)  might 
first  be  carried  to  Surplus,  and  the  appropriation  made  from  the 
latter  account.  The  entries  in  this  case  would  be  as  follows : 

d) 

Net  Revenue $75,000 

Surplus $75,ooo 

and, 

(2) 

Surplus $50,000 

Sinking  Fund  Reserve $50,000 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  307 

These  appropriations  from  annual  or  accumulated  surplus  as 
a  matter  of  accounting  are  entirely  independent  of  the  property 
accounts.  Yet  there  is  very  common  confusion  on  this  point. 
Special  funds,  it  is  true,  are  often  set  up  concurrently  with  sur- 
plus appropriations  as  was  shown  in  the  above  illustration.  But 
the  point  should  be  emphasized  that  there  is  no  necessary  connec- 
tion between  the  appropriating  of  income  or  surplus  and  the 
setting  up  of  special  funds.  Either  transaction  may  occur 
without  the  other  (subject,  of  course,  to  contractual  provisions), 
and  if  both  transactions  arise  simultaneously  there  is  no  inevitable 
coincidence  between  the  amounts  appearing  in  the  special  asset 
and  equity  accounts.  From  the  standpoint  of  protection  to  the 
bondholder  the  appropriating  of  surplus  as  a  special  sinking  fund 
reserve  is  probably  more  important  than  the  setting  up  of  special 
funds.  If  surplus  is  specifically  appropriated,  or  labeled,  so 
that  it  cannot  become  the  basis  for  cash  dividend  declarations, 
this  means  that  the  stockholders'  equity  is  being  increased  with 
a  corresponding  accumulation  of  assets.  It  is  this  process  which 
insures  the  widening  of  the  margin  that  protects  the  bondholders' 
equity. 

Sinking  Fund  Reserve  is  not  affected  by  the  repayment  of  the 
bonds.  This  can  be  clearly  shown  by  an  examination  of  the 
balance  sheets.  It  will  be  assumed  that  the  balance  sheet  of  the 
corporation  mentioned  above  at  the  date  the  bonds  were  issued 
is  as  follows : 

Property $2,000,000      Capital  Stock      .     .     .    $1,000,000 

Bonds 1,000,000 

$2,000,000  $2,000,000 


At  the  date  the  bonds  mature  the  balance  sheet  stands  as  fol- 
lows: 

Property $3,000,000      Capital  Stock      .    .    .  $1,000,000 

Bonds 1,000,000 

Sinking  Fund  Reserve  1.000,000 

$3,000,000  $3,000,000 


The  following  entries  would  be  made  when  the  bonds  are  paid : 

Bonds $1,000,000 

Cash .  $1,000,000 


3o8  PRINCIPLES  OF  ACCOUNTING 

Sinking  Fund  Reserve  can  now  be  transferred  to  surplus,  thus : 

Sinking  Fund  Reserve $1,000,000 

Surplus       $1,000,000 

The  resulting  balance  sheet  would  show  the  following  condition  : 

Property $2,000,000      Capital  Stock .    .     .     .    $1,000,000 

Surplus  ....'..       1,000,000 

$2,000,000  $2,000,000 

The  final  result  shows  simply  that  $1,000,000  in  profits  has  been 
retained  in  the  business  during  twenty  years.  In  other  words 
the  stockholders  have  accumulated  surplus  sufficient  to  buy  out 
the  bondholders.  (This  illustration  assumes  that  cash  is  avail- 
able at  the  proper  time  with  which  to  retire  the  bonds.  In  the 
case  of  an  expanding  business  the  bonds  would  probably  be  paid 
by  refunding.) 

Inexact  terminology  is  in  part  responsible  for  the  tendency 
to  confuse  property  transactions  and  the  formal  process  of  sub- 
dividing surplus.  The  term  "sinking  fund"  is  frequently  found 
in  practice  on  both  sides  of  the  balance  sheet.  On  the  left-hand 
side  it  represents  special  assets,  on  the  opposite  side  it  represents 
a  part  of  general  surplus.  Sinking  Fund  Assets  is  the  proper 
name  for  the  property  account,  and  Sinking  Fund  Reserve  for 
the  proprietary  equity  account. 


MISCELLANEOUS    SURPLUS    TRANSACTIONS    AND    APPROPRIATIONS 

A  peculiar  case  of  surplus  arises  when  contingencies  which 
have  been  anticipated  do  not  materialize.  A  shipping  company, 
for  example,  decides  to  carry  its  own  fire  insurance  by  charging 
against  revenue  each  year  the  amount  ($10,000)  which  expe- 
rience has  shown  to  be  the  average  annual  fire  loss  in  this  type 
of  business,  and  crediting  this  amount  to  an  account  entitled 
Reserve  for  Fire  Insurance,  thus : 

Expense  and  Revenue $10,000 

Reserve  for  Fire  Insurance    .     .     .  $10,000 


.  CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS    309 

If  safety  devices  and  more  efficient  management  by  the  end  of 
the  first  year  cut  down  the  fire  loss  to  one-half  of  the  previous 
estimate  a  part  of  this  valuation  reserve  may  become  a  real  sur- 
plus ;  and  in  such  a  case  it  could  properly  be  transferred  to  the 
general  surplus  account,  thus : 

Reserve  for  Fire  Insurance $5,ooo 

Surplus $5,ooo 

In  certain  cases,  a  management,  desiring  to  present  an  ultra- 
conservative  showing,  will  transfer  a  portion  of  surplus  to  an 
account  called  "Reserve  for  Contingencies,"  or  some  similar 
name,  to  cover  possible  but  unlikely  losses.  If  the  loss  is  very 
unlikely  there  is  little  to  be  said  in  favor  of  the  creation  of  such 
reserves.  Such  a  reserve  is  part  of  the  general  surplus  and 
should  be  so  considered  in  computing  total  proprietorship.  For, 
obviously,  the  proprietor's  entire  equity  is  subject  to  loss  under 
unusual  conditions.  Such  a  reserve  might  be  specifically  labeled 
to  indicate  the  nature  of  the  contingency,  as,  for  example,  "Re- 
serve for  Flood  Loss,"  or  "Reserve  for  Contingent  Deprecia- 
tion." Contingent  reserves  do  not,  of  course,  remove  risks  or 
lessen  the  burden  of  unusual  losses  to  the  stockholders.  The 
use  of  such  accounts,  however,  serves  to  suggest  to  those  inter- 
ested the  nature  of  possible  risks  inherent  in  the  business,  and 
it  reveals  the  conservative  policies  of  the  management. 

These  illustrations  serve  to  suggest  the  relation  between  valua- 
tion and  surplus  reserves.  As  was  explained  in  another  con- 
nection, asset  valuation  accounts  are  often  called  "reserves"  in 
practice.  This  is  a  confusing  practice  and,  as  was  suggested, 
the  term  "allowance"  might  well  be  substituted  for  reserve  in 
the  valuation  account.  The  two  types  of  reserve  are  seldom 
carefully  distinguished  on  the  corporate  balance  sheet,  and  since 
the  accountant  has  to  deal  with  this  situation  it  is  important  that 
the  relation  between  these  different  groups  of  accounts  be  clearly 
understood. 

In  general  the  distinction  between  a  surplus  and  a  valuation 
reserve  is  clear.  Valuation  reserves  are  supposed  to  measure  the 
expiration  of  certain  assets  which  are  left  on  the  books  for  various 
reasons  at  original  figures.  The  concurrent  charge  when  such 
an  account  is  credited  is  to  some  expense  account.  Suppose, 


310  PRINCIPLES  OF  ACCOUNTING 

for  example,  that  in  a  certain  case  the  estimated  depreciation 
of  a  company's  buildings  is  $10,000.  The  entries  recognizing  this 
accrual  would  be  as  follows : 

Depreciation  Expense $10,000 

Reserve  for  Depreciation  ....  $10,000 

The  charge  in  this  case  represents  an  expense,  a  deduction  from 
gross  revenue  which  must  be  made  before  net  revenue  can  be 
correctly  stated.  Suppose  now  that  the  management  of  this 
company  further  decides  to  appropriate  a  part  of  the  surplus 
($10,000)  as  a  reserve  for  contingent  losses  which  are  possible 
but  are  so  unlikely  that  it  is  not  possible  to  make  adequate  pro- 
vision for  them  by  means  of  insurance  as  in  the  case  of  ordinary 
risks.  The  entries  recognizing  such  an  appropriation  would  be : 

Surplus  (or  Net  Revenue) $10,000 

Reserve  for  Contingencies      .     .  „.  $10,000 

The  Reserve  for  Depreciation  account  shows  an  offset  to  over- 
stated assets  while  the  Reserve  for  Contingencies  account  repre- 
sents a  part  of  the  proprietor's  equity,  labeled  in  a  particular 
way. 

Where  a  contingent  reserve  simply  covers  the  average  accrual 
of  an  expiration  which  is  capable  of  reasonably  accurate  estima- 
tion it  becomes  an  "accrued"  reserve,  or  valuation  item.  So- 
called  contingent  reserves  are  often  of  this  type.  The  Reserve 
for  Fire  Insurance  mentioned  above  is  an  illustration  of  such  an 
account.  In  all  such  cases  the  conditions  leading  to  such  a  re- 
serve must  be  carefully  investigated  in  determining  its  real 
character. 

If  depreciation  charges  have  been  excessive,  then  a  part  of  the 
depreciation  reserve  is  really  a  surplus  item  and  may  be  trans- 
ferred to  the  Surplus  account.  If  the  depreciation  charges  have 
been  insufficient  to  cover  actual  property  expirations,  then  a  por- 
tion of  surplus  as  stated  (if  there  is  any  surplus)  is  a  valuation 
item.  Surplus  may  be  charged  and  Reserve  for  Depreciation 
credited  for  the  amount.  Due  to  the  difficulty  of  estimating 
depreciation  exactly  there  is  always  likely  to  be  some  small 
overlapping  between  valuation  and  actual  reserves.  This  does 


CORPORATE  PROPRIETORSHIP  —  SURPLUS  ACCOUNTS  311 

not  mean,  however,  that  these  types  of  accounts  should  not  be 
very  carefully  distinguished. 

The  term  reserve  is  also  sometimes  applied  to  accrued  liability 
items.  The  Reserve  for  Taxes  mentioned  in  a  preceding  chapter 
illustrates  an  account  with  such  an  item.  Such  a  reserve,  evi- 
dently, is  not  a  part  of  proprietorship,  but  is  an  actual  liability. 
Since  a  contingency,  properly  defined,  is  an  unlikely  or  accidental, 
but  possible  occurrence,  however,  a  reserve  which  covers  a 
contingent  liability  is  an  item  of  proprietorship  until  the  con- 
tingency materializes. 

The  nature  of  a  "secret"  reserve  was  suggested  in  Chapter  X. 
Such  a  reserve  is  an  item  of  proprietorship  which  exists  but 
which  is  not  booked.  Secret  reserves  may  be  built  up  by  charg- 
ing improvements  to  expense,  by  excessive  depreciation  charges, 
by  unreasonable  allowances  for  bad  accounts,  by  ignoring  ap- 
preciation, by  omitting  certain  assets  entirely,  or  by  overstating 
liabilities.  As  already  explained  such  practices  are  not  legitimate 
if  the  real  situation  is  known.  While  conservatism  in  accounting 
is  to  be  commended,  the  actual  understatement  of  proprietor- 
ship is  illegitimate.  The  insiders  may  know  the  facts,  but  the 
other  interests  in  the  enterprise  who  also  have  a  right  to  the 
facts  are  not  informed  as  to  the  actual  state  of  affairs.  All 
known  surplus  should  appear  on  the  books.  Certainly  it  is  one 
purpose  of  corporation  accounting  to  follow  and  present  the 
actual  status  of  the  stockholders'  equity. 

There  are  many  other  cases  of  surplus  accounts  and  surplus 
transactions.  In  railroad  accounting  a  common  illustration  of 
an  account  representing  a  special  surplus  appropriation  is  Re- 
serve for  Additions  and  Betterments.  The  journal  entries  setting 
up  an  appropriation  of  $50,000  in  such  an  account  are  as  follows  : 

Surplus $50,000 

Reserve  for  Additions 
and  Betterments $50,000 

Such  an  appropriation  is  simply  a  formal  recognition  of  the  fact 
that  income  has  been  retained  in  the  business  for  a  particular 
purpose.  The  special  surplus  account  involved  is  sometimes 
called  "Reserve  for  Improvements." 

Surplus  also  arises  where  appreciation  is  recognized,  as  was 


312  PRINCIPLES  OF  ACCOUNTING 

explained  in  a  preceding  chapter.  Gifts  present  still  another 
case.  If  a  gift  of  real  estate,  for  example,  is  made  to  the  cor- 
poration either  at  the  time  of  organization  or  later,  the  concur- 
rent credit  when  Real  Estate  is  charged  should  be  made  to  a 
special  surplus  account.  A  Donated  Surplus  account  might  well 
be  used  in  this  case.  Such  a  surplus  should  be  distinguished 
from  accumulated  income.  Surplus  may  be  increased  if  the  cor- 
poration buys  a  portion  of  its  own  stock  at  less  than  book  value. 
Surplus  is  correspondingly  diminished  if  such  stock  is  bought  at 
a  price  above  book  value. 

No  attention  has  been  given  thus  far  to  special  accounts  in- 
volved under  the  general  head  of  accumulated  loss  or  negative 
surplus.  The  possibilities  here  are  far  less  numerous.  The 
Deficit  account  should  be  used  to  show  such  a  deduction  from 
proprietorship.  Sometimes  a  deficit  which  the  company  is  un- 
willing to  recognize  as  such  is  set  up  as  a  deferred  expense  as 
explained  in  Chapter  X.  Such  an  account  may  appear  on  a 
balance  sheet  even  if  the  company  involved  is  having  fair  success. 
Usually,  however,  if  surplus  is  available  any  large  loss  should  be 
charged  against  surplus  rather  than  being  set  up  under  a  special 
head.  Sometimes  the  available  surplus  is  largely  appropriated 
in  special  accounts,  and  the  directors,  not  wishing  to  reverse  an 
established  accounting  policy,  will  allow  a  deficit  to  appear  con- 
currently with  such  special  surplus  accounts.  The  propriety 
of  any  considerable  extension  of  such  a  procedure  is  doubtful. 

Many  further  illustrations  might  be  given  of  particular  sur- 
plus accounts.  The  cases  described,  however,  are  among  the 
most  important.  Some  of  the  situations  mentioned  will  be  dealt 
with  further  in  later  chapters.  In  Part  Five  particular  atten- 
tion will  be  given  to  the  interpretation  of  such  special  proprietary 
accounts  in  the  corporate  balance  sheet.  It  should  be  em- 
phasized, in  conclusion,  that  an  important  part  of  the  accounting 
entries  in  the  case  of  the  corporation  are  of  the  formal  type,  con- 
cerned with  changes  in  the  current  proprietary  accounts  which 
are  made  for  the  most  part  upon  authorizations  by  the  board  of 
directors. 


XIV 

THE  LIABILITIES 

THE  distinction  between  proprietorship  and  liabilities  has 
already  been  emphasized  in  some  detail  in  preceding  chapters. 
In  general  the  proprietors  carry  the  greater  burden  of  risk,  are 
vested  with  the  larger  element  of  control  or  management,  and 
(as  is  implied  in  the  risk  burden  assumed)  have  residual  rights  to 
assets  as  either  income  or  principal.  The  "creditors"  (whose 
equities  constitute  the  liabilities)  assume  less  risk  and  have  less 
direct  control,  and  have  prior  or  contractual  rights  to  assets  as 
income  or  principal.  Several  chapters  have  now  been  devoted 
to  a  consideration  of  proprietorship  and  the  proprietary  accounts. 
In  the  present  chapter  —  to  complete  the  discussion  of  the  equi- 
ties —  the  important  types  of  liabilities  will  be  described,  and  the 
nature  of  some  of  the  accounting  problems  that  arise  in  connec- 
tion with  such  items  will  be  suggested.  The  more  important 
and  difficult  questions  that  concern  the  treatment  of  the  liabilities 
in  the  accounts  have  to  do  with  the  problem  of  interest  calcu- 
lation and  the  analysis  of  interest  transactions.  These  questions 
will  be  considered  in  detail  in  Part  Three  of  the  text.  This  chapter, 
therefore,  will  be  confined  primarily  to  a  more  complete  descrip- 
tion of  the  various  kinds  of  contractual  equities  than  has  been 
possible  heretofore.  Particular  attention  will  be  given  to  the 
important  classes  of  corporate  contractual  securities. 

ACCOUNTS  AND  NOTES  PAYABLE 

The  importance  of  the  division  between  fixed  and  current  items 
in  the  case  of  both  assets  and  equities  has  been  emphasized  re- 
peatedly in  the  preceding  chapters.  Similarly  it  should  be  noted 
at  the  outset  that  the  liabilities  may  be  conveniently  grouped 

313 


3H  PRINCIPLES  OF  ACCOUNTING 

into  fixed  and  current  items.  Such  a  classification  in  any  case 
is  not  only  an  important  matter  of  principle  but  has  a  very 
practical  significance  in  the  determination  of  the  financial  status 
of  a  given  enterprise.  A  division  of  the  liabilities  of  a  company 
into  funded  or  long-term  indebtedness  and  floating  or  short-term 
obligations  would  serve  to  throw  considerable  light  upon  the 
immediate  financial  status  of  the  enterprise.  Typical  liabilities 
may  be  settled  or  retired  only  with  cash  or  an  equivalent,  and  the 
position  of  an  enterprise  showing  a  satisfactory  relation  between 
total  proprietorship  and  total  liabilities  might  as  a  matter  of  fact 
be  precarious  if  an  undue  proportion  of  the  outside  equities  were 
of  the  short-term  type.  In  the  preparation  of  a  balance  sheet, 
therefore,  the  classification  of  the  liabilities  into  groups  is  a  matter 
of  importance,  and  in  the  case  of  an  enterprise  with  a  complex 
capitalization  such  classification  may  be  carried  very  far  —  much 
beyond  a  simple  division  into  fixed  and  current  items.  If  a 
management  is  to  adopt  at  all  times  a  financial  program  which 
will  meet  the  exigencies  of  the  capital  market  and  the  general 
industrial  situation,  it  is  necessary  that  the  accounts  and  state- 
ments present  an  intelligible  analysis  of  the  liabilities. 

Among  the  current  liabilities  an  equity  which  is  of  almost 
universal  occurrence  is  that  represented  by  the  accounts  payable. 
An  account  payable  is  usually  based  on  a  verbal  or  informal 
promise  to  pay.  Such  liabilities  originate  most  commonly  when 
a  company  buys  merchandise,  materials,  supplies  or  other  assets 
on  credit,  or,  in  other  words,  postpones  payment.  Accounts 
payable  usually  run  from  ten  to  ninety  days. 

The  accounting  problems  arising  in  connection  with  accounts 
payable  are  not  very  complex.  When  goods  are  purchased  on 
credit  the  asset  account  involved  is  charged  and  Accounts  Pay- 
able is  credited.  If  the  account  involves  alternative  terms  of 
settlement  special  valuation  accounts  may  be  needed,  for  accounts 
payable  are  entered  on  the  books  at  the  gross  figure  and  this 
gross  figure  in  one  way  or  another  must  be  accounted  for.  If  a 
discount  is  allowed  for  prompt  payment,  for  instance,  the  amount 
of  the  allowance  is  credited  to  an  account  such  as  Purchase  Dis- 
counts. As  previously  explained  such  discounts  are  in  effect 
deductions  from  the  cost  of  goods  purchased.  In  this  connec- 
tion there  is  a  sense  in  which  it  might  be  said  that  an  account 


THE  LIABILITIES  315 

payable  depreciates.  If  an  account  appearing  on  the  books  at 
$500  is  settled  in  full  for  $490  in  cash,  the  account  is  virtually 
written  down.  This  is  a  revaluation  only  in  a  fictitious  sense, 
however,  as  the  account  was  really  overstated  to  the  amount  of 
$10  in  the  first  instance.  When  the  account  is  paid  the  amount 
of  this  overstatement  is  transferred  to  a  valuation  account. 

The  interests  represented  by  the  accounts  payable  are  usually 
equities  in  the  enterprise  only  in  a  limited  sense.  When  one  mer- 
chant sells  another  merchant  goods  the  relation  between  the 
two  is  essentially  a  buyer  and  seller  relationship,  and  the  seller 
does  not  invest  his  capital  in  the  enterprise  of  the  buyer.  Yet 
if  the  buyer  postpones  payment  the  vendor  has  a  claim  against 
the  vendee  equivalent  to  the  price  of  the  goods  involved  —  a 
claim  enforceable  by  regular  legal  procedure  if  payment  is  not 
made  as  stipulated  or  within  a  reasonable  time.  In  some  in- 
stances title  to  the  specific  assets  involved  may  rest  for  a  time 
in  the  seller,  but  this  is  not  usually  the  case.  Instead  of  a  title 
to  the  specific  assets  sold  the  vendor  usually  has  a  general  claim 
against  the  assets  of  the  buyer  and  is  said  to  have  an  "  unsecured  " 
claim  because  he  has  no  lien  on  specific  assets  and  his  rights  are 
subsidiary  to  any  such  liens  and  other  prior  claims. 

Although  as  will  be  explained  in  the  next  chapter  interest  is 
involved  in  all  time  transactions  there  are  usually  no  explicit 
distributions  of  income  to  the  creditors  whose  claims  are  repre- 
sented by  the  accounts  payable.  The  question  of  income,  how- 
ever, is  in  part  responsible  for  the  usual  alternative  terms  of 
settlement  referred  to  above.  The  seller  of  a  bill  of  merchandise, 
for  example,  offers  a  cash  discount  of  two  per  cent  if  the  bill  is 
paid  in  ten  days.  If  the  buyer  allows  the  discount  privilege  to 
lapse  he  is  in  effect  making  a  distribution  of  income  to  the  ac- 
countholder.  Suppose  the  bill  is  for  $1,000.  The  entries  at  the 
time  of  purchase  might  be : 

Merchandise $1,000 

Accounts  Payable $1,000 

If  the  bill  is  paid  after  the  discount  lapses  the  entries  would  be : 

Accounts  Payable $1,000 

Cash $:,ooo 


31 6  PRINCIPLES  OF  ACCOUNTING 

It  may  be  said  that  of  this  charge  to  Accounts  Payable  the  amount 
of  $20  is  a  distribution  of  net  revenue  to  an  outside  interest. 
The  entries  at  the  outset,  it  might  be  urged,  should  be  as  follows : 

Merchandise $980 

Accounts  Payable $980 

and  at  the  time  of  payment, 

Accounts  Payable •  .     .       $980 

Net  Revenue  (Interest,  etc.) 20 

Cash         $1,000 

While  as  a  matter  of  theory  there  is  some  force  to  this  analysis 
it  would  probably  be  fantastic  to  attempt  to  present  it  in  the 
accounts.  As  a  matter  of  fact,  moreover,  many  factors  contrib- 
ute to  the  amount  of  discount  allowed  in  any  case  besides  the 
matter  of  interest  or  other  phases  of  income. 

Still  it  must  be  remembered  that  there  is  an  important  sense 
in  which  the  creditors  represented  by  the  open  book  accounts 
constitute  an  equity  in  the  ownership  of  the  enterprise.  In 
some  cases  accounts  draw  interest  according  to  the  terms  of  the 
sale  if  unpaid  after  a  certain  date.  In  such  a  case  contractual 
income  is  explicitly  involved.  Further  it  should  be  noted  that 
although  the  specific  items  which  make  up  the  accounts  payable 
of  a  particular  company  are  highly  current  in  character  the  total 
of  such  accounts  may  be  a  relatively  stable  amount,  and  may 
also  form  a  considerable  part  of  what  might  be  called  the  com- 
pany's capitalization.  In  other  words  the  floating  debt  repre- 
sented by  the  accounts  payable  may  be  constantly  a  significant 
part  of  total  ownership.  Occasionally  the  accounts  payable  are 
largely  in  the  hands  of  one  company  and  virtually  constitute  a 
silent  partner's  equity  from  the  accounting  standpoint.  In 
some  cases  the  claims  of  the  merchandise  creditors  mount  into 
millions  of  dollars ;  and  there  are  instances  in  which  such  creditors 
have  played  very  prominent  parts  in  the  reorganization  of  finan- 
cially embarrassed  corporations,  and  have  taken  stock  and  other 
securities  in  the  reorganized  company  in  settlement  of  their 
claims.1 

1  A  notable  example  is  found  in  the  reorganization  of  the  Westinghouse  Company 
in  1891-92.  See  Dewing,  Corporate  Promotions  and  Reorganizations,  Chapter  VII. 


THE  LIABILITIES  317 

Promissory  notes  constitute  an  important  type  of  liability. 
Such  notes  may  be  either  current  or  long-term  in  character. 
Short-term  notes  arise  primarily  in  connection  with  commercial 
transactions  similar  to  those  involving  accounts  payable.  An 
enterprise  buys  goods  and  postpones  payment  but  gives  a  prom- 
issory note,  or  written  promise  to  pay.  Such  a  liability  is  suffi- 
ciently distinct  from  an  open  book  account  that  it  is  considered 
necessary  to  set  it  up  in  a  separate  account.  The  note  itself  is 
sometimes  looked  upon  as  the  liability  rather  than  the  claim  of 
some  specific  person  or  company  and  the  highly  negotiable  nature 
of  such  instruments  makes  this  view  the  more  reasonable  as  the 
noteholder,  whoever  he  may  be,  has  the  claim  against  the  maker. 
Such  notes  may  be  drawn  with  or  without  interest.  The  fol- 
lowing illustration  shows  the  form  of  a  promissory  note : 

ANN  ARBOR,  MICH. 

April  17,  1918. 
$500 

Sixty  days  after  date  I  promise  to  pay  to  the  order  of  W.  W.  Stavin  five 
hundred  dollars,  for  value  received,  with  interest  at  six  per  cent  per  annum. 

A.   B.   POWERS. 

Transactions  involving  the  making  and  paying  of  promissory 
notes,  and  the  payment  and  accrual  of  interest  on  such  notes, 
have  already  been  explained,  and  some  further  illustrations  will 
be  given  in  the  next  chapter.  It  is  generally  true  of  notes  payable 
and  other  liabilities  that  the  problems  of  valuation  do  not  arise 
as  in  the  case  of  the  assets.  Yet  though  liabilities  do  not  depre- 
ciate or  appreciate  in  the  ordinary  sense,  the  accountant  must 
recognize  the  possibility  of  book  changes  in  the  liabilities  which 
arise  outside  of  actual  transactions.  The  book  value  of  a  lia- 
bility may  increase,  for  example,  because  of  the  accrual  of  in- 
terest. In  Part  Three  the  variations  in  the  values  of  liabilities  in 
both  directions  due  to  interest  accruals  will  be  fully  discussed. 

There  are  many  different  kinds  of  notes  and  similar  formal 
evidences  of  indebtedness.  Accepted  bills  of  exchange,  or  thirty, 
sixty  or  ninety-day  "sight"  drafts,  are  in  effect  promissory  notes 
and  may  be  treated  as  such  in  the  accounts.  Bank  "notes" 
are  a  somewhat  similar  type  of  liability.  Notes  of  this  kind  are 
usually  made  payable  to  the  bearer  on  demand  and  are  so  highly 


318  PRINCIPLES  OF  ACCOUNTING 

standardized  and  safeguarded  that  they  constitute  a  regular 
part  of  the  currency.  These  notes  are  non-interest  bearing  and 
yet  circulate  freely  at  par.  The  noteholders  in  this  case  are  a 
rapidly  changing  body  of  whom  the  bank  has  no  record.  Al- 
though the  notes  are  payable  on  demand  they  may  wander  far 
from  the  point  of  issue  and  may  circulate  indefinitely.  The 
present  issue  of  war-savings  stamps  is  an  example  of  a  kind  of 
long-term  non-interest  bearing  government  note.  Interest  is, 
however,  involved  in  such  an  instrument  in  that  the  note  accrues 
to  par  during  its  life. 

The  equity  of  the  noteholders,  also,  may  constitute  in  a  given 
case  an  important  element  in  total  ownership ;  and  the  interest 
accrued  on  notes  payable  may  represent  a  significant  distribu- 
tion of  net  revenue.  Corporations  make  use  of  special  kinds  of 
notes  in  many  cases  as  an  important  means  of  raising  capital. 
Such  notes  may  run  for  several  years  and  may  constitute  an  im- 
portant equity  on  the  balance  sheet.  In  some  cases  the  note- 
holder also  may  be  virtually  a  kind  of  silent  partner,  for  although 
promissory  notes  usually  run  for  a  year  or  less  a  particular  note 
may  be  renewed  at  successive  maturity  dates  and  hence  may 
become  a  permanent  equity.  More  commonly,  however,  specific 
notes  and  accounts  payable  are  liabilities  which  must  be  actually 
paid  in  cash  within  a  comparatively  short  period.  If  the  note- 
holder does  not  contemplate  an  actual  investment  in  the  enter- 
prise of  the  maker  of  the  note,  he  will  usually  insist  upon  with- 
drawing his  capital  upon  the  termination  of  the  contract. 

ACCRUED,    DEFERRED   AND   CONTINGENT   LIABILITIES 

Accrued  liabilities  are  current  claims  which  are  recognized  at 
the  time  of  closing  the  books.  Common  examples  are  wages 
payable,  taxes  payable,  rent  payable  and  interest  payable. 
These  liabilities  are  recognized  in  the  accounts  in  order  to  pre- 
serve the  integrity  of  the  accounting  period  and  to  present  a 
correct  exhibit  of  a  company's  financial  condition  in  any  case. 
Such  items  are  usually  retired  within  a  few  days  or  weeks  after 
the  books  are  closed.  Liabilities  of  this  kind  usually  do  not 
assume  significance  in  amount,  and  hence  do  not  represent  an 
important  element  in  the  ownership  of  an  enterprise.  The 


THE  LIABILITIES  319 

laborer,  for  example,  does  not  make  an  investment  in  the  enter- 
prise in  the  ordinary  sense.  He  rather  sells  his  service  at  a  price. 
As  in  the  case  of  accounts  payable,  however,  the  postponement 
of  payment  virtually  gives  him  an  equity.  Further,  it  might 
be  noted  that  in  waiting  for  his  wages  the  laborer  actually  carries 
a  part  of  the  capital  burden  of  production.  A  small  part  of  his 
wage,  therefore,  is  really  pure  interest.  The  accountant,  how- 
ever, is  not  interested  in  the  division  of  wages  into  its  ultimate 
economic  elements.  But  he  is  interested  in  seeing  to  it  that  all 
accruals  of  expense  are  charged  against  current  revenue  and  that 
all  claims  which  must  be  met  are  shown  in  the  balance  sheet. 
The  accrued  liabilities,  as  in  the  case  of  notes  and  accounts  pay- 
able, must  be  retired  shortly  with  cash  or  an  equivalent ;  and 
unless  such  items  are  exhibited  the  accounts  do  not  present 
the  actual  financial  status  of  the  enterprise.  Occasionally  such 
accrued  items  may  accumulate  to  a  considerable  amount. 
Methods  of  accounting  for  accrued  liabilities  were  explained  in 
Chapter  VIII. 

Corporate  dividends  declared  and  payable  represent  a  special 
kind  of  current  liability.  As  was  explained  in  the  preceding 
chapter  a  dividend  payable  is  a  part  of  the  stockholders'  equity 
in  a  sense ;  yet  at  the  same  time  such  an  item  is  a  liability  in  that 
it  constitutes  an  obligation  of  the  enterprise  as  an  entity  which 
must  be  met.  Cumulative  preferred  dividends  unpaid  some- 
times come  to  represent  a  large  figure  on  the  books.  If  there  is 
small  prospect  of  payment  such  a  liability,  it  should  be  recog- 
nized, stands  on  an  entirely  different  level  from  the  regular  lia- 
bilities. 

It  is  interesting  to  note  at  this  point  the  legal  positions  of  some 
of  these  different  classes  of  liabilities  in  point  of  risk.  In  general 
accrued  wages  and  taxes  occupy  a  prior  position  to  all  other 
claims,  not  excluding  mortgage  liens.  Other  current  liabilities 
as  a  rule,  however,  are  not  in  as  favorable  a  situation  in  this 
respect.  The  claims  of  noteholders  and  accountholders  are 
usually  subject  to  the  interests  represented  by  the  funded  debt. 
Between  the  capital  liabilities  in  turn  many  differences  in  this 
connection  arise.  In  liquidation  or  reorganization  securities 
such  as  mortgage  bonds  take  precedence  over  debentures  and 
similar  equities.  As  a  rule  all  other  liabilities  rank  prior  to 


320  PRINCIPLES  OF  ACCOUNTING 

dividends  payable.  All  proprietary  equities,  of  course,  follow 
the  liabilities  as  a  class  in  rights  to  assets. 

There  are  certain  liabilities  which  are  finally  paid  not  in  cash 
but  in  commodities  or  services.  These  items  are  sometimes 
called  "  deferred  "  liabilities.  Suppose,  for  example,  that  a  newly 
organized  fire  insurance  company  inaugurates  a  big  selling  cam- 
paign and  writes  insurance  during  the  first  year  of  business  which 
yields  premiums  amounting  to  $800,000.  The  entries  covering 
the  payment  of  premiums,  it  may  be  assumed,  are  as  follows : 

Cash $800,000 

Premiums $800,000 

At  the  end  of  the  year  it  is  found  that  of  this  amount  $450,000 
represents  premiums  applicable  to  unexpired  insurance.  This 
means  that  the  company  is  obligated  to  furnish  during  future 
periods  an  amount  of  its  service,  risk-taking,  with  a  selling  value 
of  $450,000.  At  this  time  the  following  entries  might  be  made  : 

Premiums $350,000 

Revenue $350,000 

The  balance  of  the  Premiums  account  should  appear  on  the  bal- 
ance sheet  as  a  deferred  liability. 

This  is  simply  another  illustration  of  the  deferred  credits  to 
income  discussed  in  Chapter  X.  Prepayments  in  connection 
with  leases  and  similar  contracts  give  rise  to  such  items  on  the 
books  of  the  party  receiving  payment.  Such  a  liability  is  suffi- 
ciently distinctive  to  be  set  up  under  a  special  head  in  the  ac- 
counts and  statements.  In  some  cases  (as  in  the  above  illustra- 
tion) such  an  equity  may  be  one  of  the  most  important  items  on 
the  balance  sheet.  No  income  explicitly  accrues  to  such  an 
equity,  and  the  item  is  extinguished  by  the  furnishing  of  a  ser- 
vice rather  than  by  being  retired  with  cash  payments. 

A  contingent  liability  is  not  an  existing  obligation  or  equity 
but  a  possible  one.  Certain  contractual  conditions  exist  in  the 
case  of  nearly  every  enterprise  which  may  give  rise  to  liabilities 
not  appearing  on  the  books.  The  most  common  case  arises  where 
a  company  endorses  and  discounts  its  notes  receivable.  This 


THE  LIABILITIES  321 

case  and  a  possible  accounting  treatment  for  it  was  explained 
in  a  preceding  chapter.  Another  illustration  may  be  taken  from 
corporation  finance.  A  company  may  guarantee  the  dividends 
on  the  stock  of  a  subsidiary  company,  or  the  principal  and  in- 
terest of  the  subsidiary's  bonds.  Such  guarantees  imply  con- 
tingent liabilities  as  the  company  may  be  called  upon  to  make 
good  its  guarantee  from  its  own  assets.  A  terminal  company 
sometimes  furnishes  a  similar  illustration.  Several  railroad  cor- 
porations, for  example,  combine  to  organize  a  company  to  build 
joint  terminal  facilities.  Each  company  agrees  to  pay  a  certain 
percentage  of  the  operating  expenses,  and  of  the  principal  and 
interest  of  the  securities  of  the  terminal  company.  If  each  com- 
pany is  jointly  as  well  as  severally  liable  this  means  that  if  any 
of  the  parties  to  the  undertaking  should  default  on  the  agree- 
ment, the  other  companies  would  be  responsible  for  the  amount 
defaulted.  A  contingent  liability  in  the  case  of  each  company 
is  evidently  involved  in  such  a  situation. 

There  are  many  other  illustrations  of  contingent  liabilities. 
A  corporation  owning  assessable  securities  in  another  company 
is  contingently  liable  for  the  amount  of  such  possible  assessment. 
Analogously  the  company  issuing  the  security  has  a  contingent 
asset  for  the  same  amount.  In  fact,  wherever  guarantees  in- 
volving a  possible  loss  are  undertaken  there  is  a  contingent 
liability. 

In  general  it  may  be  said  that  it  seems  to  be  the  better  prac- 
tice to  omit  contingent  liabilities  from  the  books  proper  alto- 
gether for  it  is  the  function  of  the  accounts  to  present  the  actual 
situation  rather  than  the  contingent  situation.  Obviously  the 
entire  status  of  the  assets  and  equities  in  any  enterprise  might 
be  radically  altered  by  contingent  circumstances  easily  conceiv- 
able. Where  a  definite  possibility  exists  it  might  be  recognized 
by  a  footnote  on  the  balance  sheet.  Indeed  the  use  of  supple- 
mentary forms  and  statements  to  present  certain  facts  which  do 
not  directly  affect  either  the  assets  or  the  equities  but  neverthe- 
less have  an  important  bearing  upon  the  general  financial  status 
and  prospects  of  the  enterprise  might  well  be  extended.  From 
the  auditor's  viewpoint  contingencies  of  a  definite  kind  cannot  be 
entirely  ignored  in  the  financial  statements. 


322  PRINCIPLES  OF  ACCOUNTING 


MORTGAGES  AND   BONDS 

A  mortgage  is  a  liability  consisting  essentially  in  a  lien  upon 
some  specific  asset  or  assets  or  upon  the  general  assets  of  some 
enterprise.  Such  instruments  as  mortgages,  particularly  real 
estate  mortgages,  may  run  for  a  long  period  of  years.  A  mort- 
gage normally  carries  an  interest  rate  corresponding  roughly  to 
the  prevailing  rate  on  promissory  notes  (sometimes  a  little  lower) . 
The  typical  mortgage  carries  rights  to  income  and  principal  which 
are  prior  to  the  claims  of  the  unsecured  general  creditors. 

There  are  many  kinds  of  mortgages.  The  mere  name  mort- 
gage does  not  always  carry  with  it  the  degree  of  security  which 
the  investor  in  mortgages  traditionally  attaches  to  such  instru- 
ments. Mortgages  may  be  placed  upon  real  estate,  equipment, 
or  almost  any  other  kind  of  asset.  Mortgages  may  be  first, 
second,  third,  etc.  In  the  distribution  of  income  or  in  the  liquida- 
tion of  capital  assets  in  any  case  the  mortgage  holders  stand  in 
order  according  to  the  kind  of  mortgage  held  by  each  class.  A 
first  mortgage,  as  the  name  implies,  is  in  general  a  much  more 
substantial  equity  than  a  second  or  any  subsequent  mortgage. 
A  first  mortgage  on  the  plant  of  a  manufacturing  company  which 
amounts  to  but  ten  per  cent  of  the  value  of  the  property,  is  but 
little  safer,  however,  than  a  second  mortgage  on  the  same  prop- 
erty for  an  additional  ten  per  cent. 

The  accounting  for  mortgages  payable  is  similar  to  that  for 
notes  payable.  The  amount  of  the  mortgage  is  credited  to  the 
Mortgages  Payable  account,  and  the  amount  of  cash  or  other 
assets  received  is  debited  to  the  appropriate  property  account. 
Discounts  on  ordinary  mortgages  seldom  arise.  The  amount 
invested  is  equal  to  the  face  of  the  mortgage.  In  other  words 
the  stated  interest  rate  is  usually  the  effective  market  rate  for 
the  particular  type  of  equity  involved.  Arrangements  are  com- 
monly made  by  which  a  mortgage  may  be  paid  in  installments ; 
in  other  cases  the  entire  amount  may  be  paid  only  at  maturity. 
Interest  is  usually  paid  either  once  or  twice  per  year. 

The  holder  of  the  typical  real  estate  or  chattel  mortgage  has 
little  control  of  the  operation  of  the  enterprise  involved.1  If 

1  Mortgages  are  also  a  common  type  of  indebtedness  involved  in  the  ownership 
of  assets  such  as  dwelling  houses,  which  are  not  used  in  production. 


THE  LIABILITIES  323 

interest  or  principal  is  defaulted  the  mortgagee  may  foreclose 
and  possibly  force  the  sale  of  the  incumbered  assets  to  satisfy 
his  equity.  The  mortgage  contract  sometimes  contains  a  pro- 
vision empowering  the  mortgagee  to  sell  the  mortgaged  property 
upon  the  non-payment  of  the  debt,  and  to  apply  the  proceeds  to 
the  liquidation  of  the  mortgage.  Such  special  mortgages  may 
eliminate  the  need  for  foreclosure  proceedings. 

As  was  stated  in  a  preceding  chapter  the  most  common  type 
of  liability  arising  in  American  corporation  finance  is  the  bond. 
A  bond  is  a  formal  instrument  of  indebtedness  widely  used  by 
incorporated  companies  in  raising  capital.  As  an  illustration  of 
the  extent  to  which  such  securities  are  issued  it  might  be  noted 
that  of  the  total  capitalization  of  American  railway  companies 
over  fifty  per  cent  is  represented  by  various  types  of  bonds. 
Bonds  are  also  commonly  issued  by  manufacturing  companies 
and  other  industrials.  In  fact  comparatively  few  large  corpora- 
tions are  financed  entirely  by  stock  issues. 

The  general  distinction  between  stocks  and  bonds  has  already 
been  explained.  The  point  should  be  reiterated  that  the  investor 
in  a  corporation  whose  equity  is  evidenced  by  a  bond  must  be 
thought  of  as  an  owner  and  not  merely  as  a  creditor  —  an  out- 
sider. In  financing  a  corporation  the  bond  issues  constitute  as 
much  a  part  of  the  original  capitalization  as  the  stock  issues. 
The  capital  furnished  by  the  bondholder  is  essentially  a  part  of 
the  permanent  investment,  and  is  furnished  to  the  corporation 
as  an  entity,  not  to  the  stockholder.  In  a  sense  all  of  the  in- 
vestors, bondholders  as  well  as  stockholders,  constitute  the 
membership  of  the  corporation. 

A  bond  consists  in  a  formal  contract  which  contains  a  promise 
to  pay  a  certain  definite  sum  ($1,000,  for  example),  the  par  of  the 
bond,  at  the  date  of  maturity,  and  certain  smaller  periodic  pay- 
ments, the  bond  interest.  A  bond  is  a  long-term  security.  The 
different  issues  run  from  ten  to  fifty  years,  or  even  longer.  The 
bond  interest  is  usually  paid  twice  a  year.  Bonds  may  be  either 
coupon  or  registered.  A  coupon  bond  is  not  made  out  in  the 
name  of  any  particular  person  and  hence  is  readily  negotiable. 
The  principal  is  made  payable  to  the  bearer,  and  the  interest  is 
paid  to  whoever  presents  the  detached  interest  coupons.  A 
registered  bond  is  registered  on  the  books  of  the  company  in  the 


324  PRINCIPLES  OF  ACCOUNTING 

name  of  a  particular  party,  and  interest  and  principal  are  then 
payable  only  to  the  registered  holder.  Such  a  security  may  be 
transferred,  however,  in  much  the  same  manner  as  a  stock  cer- 
tificate. 

Bond  issues  are  often  based  upon  mortgages.  A  corporation 
desiring  to  raise  capital  may  place  a  mortgage  on  its  properties 
somewhat  similar  to  the  ordinary  mortgage.  The  corporation 
would  have  difficulty,  however,  in  raising  the  necessary  capital 
directly  on  the  basis  of  a  single  mortgage  contract.  The  mort- 
gage is  therefore  deposited  with  a  trustee,  and  an  issue  of  bonds, 
secured  by  the  mortgage,  is  emitted.  The  individual  bonds  can 
then  be  written  in  convenient  denominations  and  can  be  readily 
sold  to  investors. 

The  mortgage  contract  is  often  an  elaborate  document  giving 
to  the  bondholder  a  considerable  degree  of  indirect  control  over 
the  general  business  and  financial  policies  of  the  corporation.  If 
interest  or  principal  is  defaulted  the  bondholder  comes  into 
almost  complete  control  of  the  affairs  of  the  corporation  under 
the  mortgage  right  of  foreclosure.  The  tendency  in  corpora- 
tion finance  seems  to  be  more  and  more  toward  the  placing  of 
limitations  upon  the  absolute  control  of  the  stockholder. 

There  are  many  types  of  mortgage  bonds.  In  the  first  place 
a  bond  may  be  issued  on  the  basis  of  a  mortgage  covering  only 
a  part  of  the  corporation's  property,  or  the  mortgage  may  con- 
stitute a  lien  upon  all  of  the  present  assets  and  any  assets  that 
may  be  acquired  in  the  future  as  well.  Further,  a  succession  of 
mortgages,  and  corresponding  bond  issues,  may  be  issued  against 
the  same  property.  All  kinds  of  combination  mortgages  are 
used.  A  particular  bond  issue,  for  example,  may  be  based  upon 
a  first  mortgage  upon  some  assets  and  a  third  mortgage  upon 
other  assets.  The  name  used  in  the  prospectus  is  often  not  a 
reliable  index  of  the  nature  of  the  security  back  of  the  bond  issue. 
A  careful  inquiry  into  the  nature  of  the  mortgage  contract  upon 
which  the  security  rests  might  well  be  made  by  the  prospective 
investor. 

"Debenture"  bonds  and  "income"  bonds  represent  other 
types  of  corporate  equities.  The  debenture  bondholder,  in  the 
absence  of  special  stipulations,  is  in  much  the  same  position  as 
the  general  creditor.  Debenture  bonds  are  often  issued  by  a 


THE  LIABILITIES  325 

corporation  which  already  has  outstanding  mortgage  bonds.  In 
other  cases  a  corporation  will  issue  this  type  of  security  and  make 
no  use  of  mortgages.  Although  debentures  do  not  carry  the 
privileges  of  mortgage  bonds  a  particular  issue  may  represent  a 
very  conservative  investment.  In  general  the  character  of  cor- 
porate liabilities  is  determined  in  large  measure  by  the  nature 
of  the  particular  enterprise  involved  in  any  case  as  well  as  by  the 
special  contractual  privileges  which  obtain. 

Income  bonds  have  not  proved  to  be  a  desirable  form  of  secur- 
ity. The  income  bondholder  has  very  little  control,  either  direct 
or  contingent.  The  interest  is  paid  only  if  earned.  There  are 
so  many  possibilities  of  manipulating  the  accounting  treatment 
of  transactions  affecting  net  revenue  in  such  a  case  to  the  ad- 
vantage of  the  common  stockholder  that  it  is  very  difficult  to 
protect  the  interests  of  the  bondholders  adequately.  The  stock- 
holder is  content  to  see  income  retained  in  the  business  so  that  a 
dividend  may  be  earned  on  this  property  in  the  future.  The 
methods  of  building  up  secret  reserves  referred  to  in  the  last 
chapter  may  be  employed  to  the  bondholder's  disadvantage. 
In  the  absence  of  a  very  complete  governmental  or  contractual 
control  of  the  accounting  procedure  it  is  difficult  to  prevent  such 
practices,  or  to  secure  redress  for  the  bondholder. 

There  are  still  more  highly  specialized  kinds  of  bonds  than  any 
yet  mentioned.  "Equipment"  bonds  may  be  secured  by  liens 
upon  specific  units  of  equipment  such  as  railway  cars  or  vessels. 
"Collateral"  bonds  are  based  upon  a  subsidiary  issue  of  stock 
or  bonds  held  by  a  trustee.  Such  bonds  are  often  used  in  con- 
nection with  a  combination  of  two  or  more  enterprises  by  means 
other  than  an  actual  merger.  A  company,  for  example,  may 
borrow  sufficient  funds  on  promissory  notes  to  buy  a  large  or 
controlling  interest  in  the  stock  of  another  company.  This 
stock  may  then  be  deposited  with  a  trustee  and  be  made  the  basis 
of  an  issue  of  the  holding  company's  own  bonds,  the  proceeds 
from  the  sale  of  which  may  be  used  to  retire  the  outstanding 
notes.  "Serial"  and  "convertible"  bonds  are  often  issued,  par- 
ticularly in  the  case  of  mining  and  similar  companies.  A  serial 
bond  issue  is  one  in  which  the  bonds  mature  in  regular  install- 
ments. Convertible  bonds  may  be  exchanged  for  stocks  under 
certain  conditions. 


326  PRINCIPLES  OF  ACCOUNTING 

The  corporate  form  of  organization  is  indeed  marvelously 
well  adapted  to  the  specialization  of  equities.  There  is  prac- 
tically no  limit  to  the  possible  variations  in  corporate  securities 
which  may  be  devised  by  ingenious  financiers.  By  means  of 
different  kinds  of  stocks  and  bonds  the  tastes  of  practically  every 
type  of  investor  may  be  suited.  All  of  the  important  sources  of 
capital  in  the  community  may  thus  be  tapped  in  the  organiza- 
tion of  a  single  large  corporation.  In  this  respect  the  simple 
partnership  or  single-proprietorship  is  comparatively  very  much 
handicapped. 

The  more  important  accounting  questions  arising  in  connec- 
tion with  such  liabilities  as  bonds  have  to  do  with  the  calculation 
of  interest  and  principal  and  the  treatment  of  these  items  in  the 
accounts.  As  was  stated  above  this  subject  will  be  fully  discussed 
in  Part  Three  but  some  questions  arising  in  connection  with  the 
retirement  of  bonds  will  be  briefly  considered  at  this  poinj;. 

The  length  of  time  a  bond  is  to  run  should  bear  some  relation 
to  the  length  of  life  of  the  property  upon  which  the  security  is 
based.  The  amortization  of  equipment  bonds,  and  the  bonds 
of  wasting  asset  enterprises  such  as  mines  and  timber  companies, 
should  be  provided  for  in  some  regular  way.  One  method  of 
providing  for  the  maturity  of  such  liabilities  is  to  accumulate 
a  sinking  fund  out  of  revenues  sufficient  to  meet  the  obligation 
at  the  due  date.  The  chief  disadvantage  of  such  a  fund  lies  in 
the  fact  that  it  will  usually  earn  a  rather  low  rate  of  interest  since 
it  must  be  invested  in  high-grade  securities  in  order  to  serve  its 
purpose.  Another  method  is  to  issue  the  bonds  with  serial  re- 
tirement dates,  though  such  a  bond  issue  has  certain  disad- 
vantages. If  emitted  at  a  discount  serial  bonds  cannot  be  priced 
evenly  on  the  market  and  this  makes  the  security  unattractive 
to  the  investor.  Those  bonds  which  have  the  shortest  time  to 
run  will  sell  for  higher  prices  than  the  blocks  with  a  longer  life.1 
Still  another  way  to  reduce  the  liability  is  to  buy  an  amount  of 
bonds  on  the  market  each  year  equivalent  approximately  to  the 
amount  of  an  appropriate  sinking  fund  installment  plus  the  ac- 
cumulation on  such  a  fund. 

Bonds  called  or  bought  back  by  the  issuing  corporation  present 

1  The  reason  for  such  a  pricing  will  become  evident  as  the  chapters  on  interest 
transactions  are  studied. 


THE  LIABILITIES  327 

essentially  the  same  accounting  problem  as  treasury  stock.  Such 
bonds  may  be  kept  "alive"  in  the  treasury  or  may  be  cancelled. 
As  in  the  case  of  treasury  stock,  however,  the  bond  of  a  corpora- 
tion in  its  own  treasury  is  always  virtually  "dead."  It  could 
not  be  issued  again  as  it  stands.  Such  bonds  are  not  an  asset 
but  a  deduction  from  the  amount  of  the  outstanding  liabilities. 
The  claim  which  a  corporation  holds  against  itself  can  hardly 
be  considered  an  asset.  If  listed  among  the  assets  redeemed 
bonds  should  be  considered  as  a  valuation  item. 

In  conclusion  certain  special  types  of  securities  somewhat  akin 
to  bonds  should  be  mentioned.  Perpetual  liabilities,  or  per- 
petuities, are  not  common  in  American  finance,  but  there  are  a 
few  cases  of  such  equities.  A  perpetuity  is  essentially  a  bond 
having  no  due  date.  The  bond  does  not  mature,  hence  there  is 
no  provision  made  for  the  repayment  of  the  principal  investment. 
In  this  respect  such  a  security  is  similar  to  a  stock  issue.  In- 
come, however,  accrues  on  a  contractual  basis  and  the  holder  of 
the  perpetuity  usually  has  little  or  no  control.  The  English 
consols  are  an  example  of  a  government  security  of  this  type. 

Insurance  companies  sometimes  secure  capital  from  a  certain 
type  of  investors  on  the  basis  of  annuities.  The  annuity  as  a 
security  is  an  instrument  containing  the  promise  to  pay  to  the 
investor  a  certain  number  of  annual  sums,  though  a  series  of 
semiannual  or  quarterly  payments  may  also  be  called  an  annuity. 
In  the  case  of  life  annuities  the  number  of  payments  depends  upon 
the  length  of  life  of  the  investor  or  beneficiary.  The  investor 
in  an  annuity  furnishes  a  certain  amount  of  capital  and  receives 
a  series  of  contractual  sums.  Income  and  principal  are  both 
involved  in  these  payments.  The  calculations  and  accounting 
problems  arising  in  connection  with  annuities  will  be  fully  dis- 
cussed in  Chapters  XVI  and  XVII. 


PART  THREE 
THE  INTEREST  PROBLEM 


XV 

A  GENERAL  ANALYSIS  OF  THE  INTEREST  PROBLEM 

FREQUENT  reference  has  been  made  in  preceding  chapters  to 
transactions  involving  interest .  Particularly  in  Par t  Two ,  in  con- 
nection with  the  equity  accounts,  it  has  been  necessary  to  mention 
the  importance  of  interest  in  the  accounting  records,  and  to  stress 
the  fact  that  the  distribution  of  net  revenue  to  the  various  classes 
of  equities  is  largely  based  on  the  interest  contract.  In  the  suc- 
ceeding chapters,  moreover,  especially  in  Part  Four,  on  the  valua- 
tion of  assets,  this  question  will  arise  repeatedly.  In  all  cases 
where  it  has  been  necessary  to  recognize  interest,  the  question 
of  its  computation  has  been  deferred  to  this  part  of  the  text  as 
many  purely  technical  questions  are  presented  in  connection  with 
the  computation  of  interest  and  the  analysis  of  transactions  in- 
volving the  interest  phenomenon.  Several  chapters  of  the  book 
will  now  be  concerned  with  the  more  important  of  these  questions. 
Many  of  the  topics  discussed  here  have  already  been  mentioned 
in  connection  with  the  equity  accounts,  and  some  will  again  be 
taken  up  in  connection  with  the  asset  accounts.  This  part  will 
therefore  serve  as  a  technical  basis  for  the  other  problems  men- 
tioned. 

THE   INTEREST  PHENOMENON 

The  interest  phenomenon  presents  itself  in  two  different  forms 
in  connection  with  business  transactions.  In  economic  discus- 
sions these  are  called  "explicit"  and  "implicit"  interest  trans- 
actions, and  the  accountant  needs  to  understand  the  distinction 
thoroughly.  Explicit  interest  is  the  type  of  interest  explicitly 
mentioned  in  definite  credit  relations  expressed  by  some  form  of 
contract  such  as  promissory  notes,  mortgages,  bonds,  etc.  Im- 
plicit interest  refers  to  the  interest  involved  in  the  ownership  of 
any  durable  asset  and  is  an  important  accounting  consideration 

331 


332  PRINCIPLES  OF  ACCOUNTING 

because  the  difference  between  the  immediate  purchase  price  of 
such  an  asset  item  and  the  sum  totak  of  the  revenues  which  it 
will  produce  in  the  future  represents  in  part  at  least  implicit 
interest.  This  is  what  is  meant  when  the  manager  says  that  in 
addition  to  providing  for  other  items,  the  selling  price  of  his 
product  must  be  high  enough  to  pay  interest  on  his  investment. 

Explicit  interest  as  was  stated  above  arises  in  connection  with 
contractual  loans.  A  large  part  of  the  capital  invested  in  the 
average  business  enterprise  is  obtained  through  what  is  commonly 
termed  borrowing.  The  firm  issues  some  form  of  promissory 
obligation  in  exchange  for  present  funds  to  be  used  in  obtaining 
various  asset  items.  The  amount  of  the  funds  received  is  less 
than  the  amount  which  the  firm  promises  to  repay  in  the  future. 
This  difference  is  explicit  interest.  It  is  convenient,  however, 
to  classify  the  forms  of  loans  of  this  type  into  two  classes  on  the 
basis  of  the  length  of  time  involved  in  each  case.  From  the  ac- 
countant's point  of  view  the  first  class,  called  short-term  notes, 
are  all  such  obligations  which  run  for  periods  less  than  a  year. 
The  banker  is  inclined  to  call  all  such  obligations  which  run  for 
over  ninety  days  "  long-term ,"  but  the  accountant  classifies  as  long- 
term  securities  only  those  which  run  for  a  year  or  longer  periods. 

Short-term  notes  are  given  usually  for  the  purpose  of  raising 
current  funds  to  meet  current  liabilities.  Bankers  speak  of  this 
form  of  loan  as  a  merchandising  loan.  The  manufacturer  bor- 
rows on  his  sixty-day  note  to  enable  him  to  make  immediate 
payment  for  his  materials  and  labor  while  waiting  for  payment 
from  his  customer  the  jobber.  The  jobber  in  turn,  on  receipt 
of  goods  from  the  manufacturer,  borrows  on  his  sixty-day  note 
in  order  to  make  prompt  payment  while  waiting  for  receipts  from 
his  own  customers,  for  example,  the  retailers.  These  are  all  short- 
term  loans  made  for  the  purpose  of  financing  immediate  pur- 
chases. The  assets  obtained  are  listed  among  the  current  assets 
and  the  notes  are  listed  among  the  current  liabilities.  Likewise 
the  interest  involved  is  usually  placed  in  the  Commercial  Interest 
account.  The  complications  which  arise  in  connection  with  this 
class  of  loans  will  be  discussed  more  fully  in  the  next  section. 

Long-term  securities  are  issued  primarily  for  the  raising  of 
capital  to  be  invested  in  fixed  assets  and  hence  usually  run  for 
a  much  longer  period  than  promissory  notes.  Bonds,  long-term 


ANALYSIS  OF  THE  INTEREST  PROBLEM  333 

notes,  annuities,  etc.,  characteristic  of  this  class,  run  for  periods 
of  from  one  to  one  hundred  years.  Most  bonds,  however,  run 
for  less  than  one  hundred  years  though  some  securities,  such  as 
the  British  consols,  run  in  perpetuity.  The  assets  obtained  from 
these  security  issues  therefore  will  largely  be  represented  in  the 
fixed  asset  accounts  while  the  securities  themselves  will  be  placed 
among  the  capital  equities.  Moreover,  the  interest  involved  is 
placed  in  special  interest  accounts ;  in  fact  it  is  often  deemed  ad- 
visable to  keep  a  special  interest  account  for  each  security  out- 
standing, and  this  class  of  interest  transactions  will  therefore  be 
discussed  further  in  a  later  section. 

It  is  unnecessary  at  this  point  to  go  into  a  lengthy  discussion 
of  the  nature  and  origin  of  interest,  but  it  is  essential  for  the  ac- 
countant to  realize  that  interest,  either  explicit  or  implicit,  enters 
into  every  transaction  where  time  is  an  essential  element.  The 
fact  that  it  exists  in  every  computation  involving  time  is  very 
generally  recognized,  and  two  types  of  characteristic  calculations 
commonly  made  by  business  men  show  further  that  computations 
involving  implicit  interest  are  consciously  made.  In  the  first 
place  if  a  bid  is  to  be  made  for  the  purchase  of  an  asset  the  future 
revenues  of  which  are  definitely  known,  the  business  man  will 
discount  the  revenues,  thus  making  the  purchase  price  consider- 
ably less  than  the  sum  of  the  revenues.  This  difference  is  interest. 
The  amount  of  revenue  received  each  year  in  such  a  case  con- 
sists of,  (i)  a  return  of  part  of  the  purchase  price,  and  (2)  interest 
on  the  investment.  The  second  general  type  of  implicit  interest 
is  made  evident  when  the  manager  of  a  plant  is  about  to  state  a 
price  for  his  product ;  for  he  adds  a  certain  amount  to  the  regular 
expenses  to  "cover  the  interest"  on  his  investment.  These  two 
types  of  calculations,  of  course,  are  just  two  different  methods  of 
computing  implicit  interest.  The  first  recognizes  that  money 
due  in  the  future  must  be  discounted  to  find  its  present  value, 
and  the  second  that  interest  is  an  economic  cost  of  production. 

In  commercial  accounting  the  implicit  interest  item  is  seldom 
calculated  separately  but  is  included  with  the  profits  in  the  net 
revenue  figure.  For  instance,  the  net  revenue  figure  which  is 
carried  from  the  expense  and  revenue  statement  down  to  the 
credit  side  of  the  net  revenue  statement  includes  interest  on  the 
investment.  If  the  firm  is  prosperous  it  also  includes  a  con- 


334  PRINCIPLES  OF  ACCOUNTING 

siderable  profit,  if  poorly  managed  even  interest  will  not  be 
earned  although  this  situation  cannot  continue  without  leading 
to  bankruptcy.  The  operating  net  revenue,  then,  includes  the 
interest  return  on  the  investment.  Additions  are  made  to  this 
figure  in  the  net  revenue  statement  through  receipts  of  explicit 
interest  and  deductions  through  distributions  of  explicit  interest. 
The  final  net  balance  is  therefore  made  up  of  interest  on  the  pro- 
prietary investment  and  pure  profit. 

There  is  a  very  close  relation  between  the  interest  element  in 
operating  net  revenue  and  the  value  of  the  assets  used  in  pro- 
ducing the  revenue.  In  the  purchase  of  assets  having  definite 
future  revenues  this  value  may  be  obtained  by  a  mathematical 
computation.  The  relation  between  the  revenue  and  the  value 
of  the  asset  is  fixed  at  the  date  of  investment  by  a  discounting 
process.  In  determining  the  price  of  a  product  the  relation  is 
somewhat  more  obscure  but  is  nevertheless  present.  The  man- 
ager invests  in  a  machine  which  will  last  ten  years  because,  in 
view  of  all  the  conditions  which  he  can  foresee,  the  revenue  at- 
tributable to  the  machine  will  be  in  excess  of  the  purchase  price. 
Or,  stated  in  another  way,  he  will  fix  the  price  of  his  own  product 
at  a  point  which  will  enable  him  to  obtain  the  market  rate  of 
interest  on  the  investment.  In  any  case,  if  he  is  successful,  net 
revenue  will  yield  a  reasonable  interest  return  on  the  investment. 
There  is  then  a  relation  between  the  value  of  the  asset  and  the 
interest  return  which  should  as  far  as  possible  be  recognized  in 
the  accounts.  Its  bearing  on  the  problem  of  valuation  will  be 
discussed  at  some  length  in  Part  Four,  but  some  of  the  questions 
dealing  with  interest  in  valuations  will  be  mentioned  in  the 
last  section  of  this  chapter. 


COMMERCIAL   INTEREST 

Commercial  interest  is  the  term  generally  applied  to  interest 
paid  or  received  on  short-term  notes.  No  fixed  rule  can  be  laid 
down  as  to  what  constitutes  a  short-term  note  but  usually  it  is 
assumed  that  one  year  may  be  taken  as  the  limit  of  this  class,  as 
the  normal  purpose  of  loans  of  this  type  is  to  aid  in  the  mer- 
chandising of  goods.  Such  loans  are  made  in  order  that  the  pur- 


ANALYSIS  OF  THE  INTEREST  PROBLEM  335 

chaser  of  raw  materials  or  merchandise  can  make  prompt  pay- 
ment to  his  creditor  awaiting  the  sale  of  his  own  product  and  are 
therefore  practically  always  closely  connected  with  the  purchase 
price  of  the  raw  materials  or  merchandise  involved.  That  is, 
the  loan  is  obtained  by  the  purchaser  so  that  he  can  "take  his 
discount"  and  thus  obtain  the  goods  at  a  lower  total  cost  than 
would  be  the  case  if  he  accepted  the  credit  terms  of  the  seller. 
The  question  as  to  whether  a  short-term  loan  should  be  obtained 
usually  arises  in  somewhat  this  way.  X  purchases  goods  from 
Y  at  an  invoice  price  of  $1,000.00.  A  discount  of  2  per  cent  will 
be  allowed  if  the  bill  is  paid  within  ten  days,  but  if  it  is  not  paid 
within  that  time  the  net  must  be  paid  within  sixty  days.  X 
has  not  the  ready  funds  to  make  payment  immediately  but  his 
credit  at  the  bank  is  good  for  a  6  per  cent  rate  per  year.  He  can 
borrow  $980.00  at  6  per  cent  from  the  bank  and  immediately  pay 
Y  for  the  goods.  Then  at  the  end  of  sixty  days  he  pays  the  bank 
the  $980.00  plus  interest,  $9.80,  or  a  total  of  $989.80.  He  then 
says  that  his  goods  cost  him  $989.80  instead  of  $1,000.00  as  they 
would  have  if  he  had  waited  sixty  days  to  pay  Y.  He  has  evi- 
dently saved  $10.20  by  this  operation. 

It  was  shown  in  Chapter  VIII  that  all  commercial  interest, 
both  interest  paid  and  interest  received,  can  be  entered  in  one 
account.  This  account  then  shows  the  excess  of  interest  paid 
on  merchandising  operations  over  interest  received  or  vice  versa, 
and  in  the  ordinary  industrial  enterprise  this  net  figure  is  of  more 
significance  than  the  total  of  the  interest  on  either  notes  payable 
or  notes  receivable.  This  account  represents  the  results  of  oper- 
ations of  a  commercial  banking  character.  Interest  received  on 
notes  receivable  might  with  reason  be  considered  as  a  deduction 
from  the  total  interest  paid  on  notes  payable.  A  note  received 
from  a  customer  can  be  and  usually  is  endorsed  and  used  for 
obtaining  current  funds  from  a  bank.  If  it  is  held  a  few  days 
before  it  is  taken  to  the  bank  for  discount,  the  interest  earned  in 
those  few  days  might  properly  be  taken  as  an  offset  to  the  interest 
paid  on  notes  originating  with  the  firm.  There  are  certain  cases, 
however,  where  it  would  be  of  service  to  the  manager  to  separate 
the  accounts  so  as  to  show  the  commercial  interest  paid  in  one 
and  the  amount  received  in  another,  but  the  two  methods  of 
keeping  the  commercial  interest  were  explained  and  illustrated 


336  PRINCIPLES  OF  ACCOUNTING 

quite  fully  in  Chapter  VIII.1  (At  closing  dates  interest  accrued 
in  both  directions  is,  of  course,  taken  into  consideration.) 

Another  question  of  considerable  importance  in  connection 
with  the  Commercial  Interest  account  is  whether  the  account 
should  be  closed  into  expense  and  revenue  or  into  net  revenue 
accounts.  To  be  logically  consistent  with  the  theories  thus  far 
developed  in  this  text,  interest  should  be  considered  as  a  dis- 
tribution of  net  revenue  to  the  equities  represented  by  the  Notes 
Payable  account.  In  the  average  enterprise  a  not  inconsiderable 
part  of  the  working  capital  is  supplied  through  this  medium,  and 
this  is  good  policy.  Should  not  interest  on  these  notes  then  be 
considered  in  the  same  category  with  interest  on  bonds  as  a  dis- 
tribution of  net  revenue? 

There  are,  however,  good  practical  reasons  for  charging  this 
form  of  interest  to  expense  (or  crediting  it  to  gross  revenue  in  the 
case  of  a  credit  balance).  The  borrowing  operation  as  was  shown 
above  is  directly  connected  with  the  price  of  goods  purchased 
(or  sold).  By  obtaining  the  loan  the  purchase  price  of  goods  is 
less  even  after  interest  is  paid  on  the  loan  than  it  would  be  if  the 
alternative  terms  of  settlement  were  accepted.  As  it  is  customary 
to  charge  the  Materials  account  with  the  invoice  price  and  to 
credit  a  valuation  account,  Merchandise  Discount,  for  the  dis- 
counts actually  taken,  there  is  some  reason  for  charging  interest 
on  commercial  loans  against  the  operating  accounts.  That  is, 
since  the  whole  matter  is  tied  up  with  the  purchase  transaction  and 
the  merchandise  discount,  the  statements  for  practical  purposes 
will  be  as  significant  with  this  kind  of  interest  in  the  expense  and 
revenue  statement  as  through  the  more  logical  method  of  treating 
it  as  a  distribution  of  net  revenue.  The  location  of  such  items, 
in  other  words,  may  be  based  entirely  on  practical  considerations. 

In  a  bank  the  case  is  clear ;  commercial  interest  is  gross  rev- 
enue. Expenses  of  conducting  the  bank  are  met  out  of  the  com- 
mercial interest  received.  The  bank  organization  is  maintained 
primarily  for  the  purpose  of  furnishing  this  service  and  of  course 
expenses  incurred  in  furnishing  such  services  must  be  deducted 
from  the  revenue  received  from  the  sale  before  obtaining  net 

1  It  is  suggested  that  the  student  at  this  point  review  the  section  on  closing  of 
interest  accounts  (pages  188-189)  m  order  to  have  clearly  in  mind  the  different 
elements  entering  into  such  an  account. 


ANALYSIS  OF  THE  INTEREST  PROBLEM  337 

revenue.  This  does  not  necessarily  mean  that  the  debit  on  the 
borrower's  books  must  also  be  entered  in  the  Expense  and  Revenue 
account  but  it  lends  considerable  weight  to  that  contention. 

A  consideration  of  a  few  of  the  typical  transactions  involving 
commercial  interest  will  lend  concreteness  to  the  discussion. 
The  most  common  case  has  already  been  mentioned,  namely 
the  borrowing  or  loaning  on  an  interest  bearing  promissory  note. 
The  X  Company  borrows  $1,000.00  from  a  bank  on  a  sixty-day 
6  per  cent  note.  On  the  date  of  borrowing,  the  entries  are, 

Cash $1,000.00 

Notes  Payable $1,000.00 

Then  at  the  end  of  sixty  days,  when  the  note  is  paid,  the  entries 
will  be, 

Notes  Payable $1,000.00 

Commercial  Interest 10.00 

Cash $1,010.00 

Another  form  of  borrowing  frequently  used  is  through  a  non- 
interest  bearing  note.  That  is,  the  X  Company  brings  to  the 
bank  its  promise  to  pay  $1,000.00  at  the  end  of  sixty  days  without 
interest.  In  this  case  the  payment  to  be  made  by  X  at  the  end 
of  sixty  days  is  just  $1,000.00  and  no  more.  The  bank  then  will 
discount  this  note  at  the  bank  rate  of  discount  and  give  X  the 
proceeds.  Six  per  cent  of  $1,000.00  for  sixty  days  is  $10.00. 
The  net  proceeds  of  the  note  therefore  are  $990.00  and  the  en- 
tries on  X's  books  are, 

Cash $990.00 

Discount  on  Notes  Payable 10.00 

Notes  Payable $1,000.00 

The  amount  of  the  discount  is,  of  course,  interest  but  this  in- 
terest accrues  during  the  ensuing  sixty  days.  As  Discount  on 
Notes  Payable  stands  on  the  books  at  present  it  is  a  valuation 
account  offsetting  the  overstatement  of  the  liability  on  notes 
payable.  At  the  end  of  sixty  days  the  full  $1,000.00  is  paid  and 
the  entries  would  be, 

Notes  Payable $1,000.00 

Cash $1,000.00 

z 


338  PRINCIPLES  OF  ACCOUNTING 

By  this  time  the  interest  of  $10.00  has  accrued  and  should  be 
charged  to  Commercial  Interest, 

Commercial  Interest $10.00 

Discount  on  Notes  Payable  ....  $10.00 

Because  of  the  short  time  which  elapses  between  the  date  of  issue 
and  date  of  payment  of  such  a  note,  it  is  considered  good  policy 
to  charge  the  discount  to  Commercial  Interest  at  the  time  the 
loan  is  made.  In  this  way  the  necessity  for  making  this  last  entry 
is  avoided.  If  all  of  the  interest  on  such  a  note  has  not  accrued 
at  the  time  of  closing  the  books,  the  accrued  amount  can  be 
taken  into  account  through  the  inventories.  Commercial  Interest, 
then,  could  have  been  charged  originally  instead  of  Discount  on 
Notes  Payable.  The  point  to  be  emphasized,  however,  is  that 
the  interest  accrues  during  the  ensuing  period. 

While  interest  and  discount  as  they  appeared  in  the  last  two 
illustrations  are  fundamentally  the  same  thing,  attention  should 
be  called  to  a  difference  between  the  rate  of  interest  and  the  rate 
of  discount.  The  rate  of  interest  is  applied  to  the  present  sum 
to  obtain  the  amount  to  be  added  for  interest.  The  rate  of  dis- 
count is  applied  to  the  sum  due  in  the  future  to  obtain  the  amount 
to  be  deducted  for  discount.  It  is  obvious  that  a  certain  rate  of 
discount  would  give  a  higher  rate  of  interest  on  the  present  value  of 
a  sum.  To  illustrate,  the  non-interest  bearing  note  for  $1,000.00 
which  was  discounted  at  6  per  cent  for  sixty  days  brought  $990.00. 
The  item  of  $10.00  is  interest.  The  rate  of  interest  involved  in 
the  transaction  is  greater  than  6  per  cent  however,  as  the  in- 
terest on  $990.00  at  6  per  cent  for  sixty  days  is  only  $9.90. 
The  borrower  then  pays  a  higher  rate  of  interest  than  the  stated 
rate  of  discount  if  he  has  a  non-interest  bearing  note  discounted 
at  the  bank.  The  relation  between  the  two  rates  is  given  in  a 
mathematical  formula  in  the  next  chapter. 

Minor  questions  sometimes  arise  in  matters  regarding  interest 
where  custom  is  primarily  the  guide.  In  computing  interest 
on  short-term  notes,  for  instance,  the  student  may  be  in  doubt 
as  to  whether  to  figure  360  or  365  days  to  the  year.  There  is 
no  absolute  uniformity  in  practice  in  this  matter  but  certain 
customs  are  general  enough  in  extent  to  warrant  a  statement  of 
them  in  the  form  of  rules.  The  year  is  generally  taken  as  360 


ANALYSIS  OF  THE  INTEREST  PROBLEM  339 

days  for  computations  involving  the  use  of  odd  days.  Sixty 
days,  for  example,  is  one-sixth  of  a  year.  The  note  itself,  how- 
ever, may  specify  that  365  days  shall  be  used  as  a  basis.  The  next 
shorter  unit  of  time  than  the  year  is  the  month.  The  month  is 
always  considered  to  be  the  period  between  the  dates  of  equal 
number  including  the  second  number.  That  is  one  month  from 
January  1 5th  is  February  i5th.  A  note  due  one  month  from  the 
former  date  must  be  paid  on  the  latter.  One  month  from  Jan- 
uary 3ist,  however,  is  February  28th  (or  2gth  in  a  leap  year). 
Thirty  days  and  one  month  are  usually  considered  as  synony- 
mous terms  although  in  some  cases  the  actual  number  of  days  is 
counted.  In  other  words,  one-twelfth  of  a  year  is  either  thirty 
days  or  one  month. 

Other  forms  of  paper  which  are  classed  as  notes  payable,  or 
notes  receivable,  are  time  drafts,  trade  acceptances,  bills  of  ex- 
change, etc.  Each  of  these  forms  of  paper  is  somewhat  dis- 
tinctive as  to  legal  form  but  in  accounting  all  are  properly  treated 
as  commercial  notes.  If  X  sells  a  bill  of  goods  to  Y  and  then 
draws  a  draft  on  Y  which  is  properly  accepted,  the  draft  becomes 
a  promissory  note.  It  is  a  note  payable  on  Y's  books  and  a  note 
receivable  on  X's  books.  The  same  would  be  true  of  other  forms 
of  commercial  paper  of  this  general  character. 

An  industrial  concern  may  receive  a  large  number  of  promissory 
notes  from  its  customers  in  the  ordinary  conduct  of  its  business. 
If  these  are  retained  until  maturity,  the  entries  would  be  the 
reverse  of  those  made  on  the  books  of  the  customer,  except  that 
Notes  Receivable  would  be  the  title  of  the  account  representing 
the  notes  instead  of  Notes  Payable.  The  notes  are  usually  ob- 
tained, however,  in  order  to  use  them  for  immediate  discounting 
purposes.  The  Notes  Receivable  account  then  is  credited,  Cash 
debited  for  the  proceeds,  and  the  Commercial  Interest  account 
debited  if  the  proceeds  are  less  than  the  face  of  the  note  or 
credited  if  the  proceeds  are  more  than  the  face  of  the  note. 

LONG-TERM   SECURITIES 

Interest  on  long-term  securities  is  unquestionably  a  deduction 
from  net  revenue.  Such  securities  are  issued  for  the  purpose  of 
raising  the  capital  to  be  retained  permanently  in  the  enterprise, 


340  PRINCIPLES  OF  ACCOUNTING 

and  accruals  of  interest  are  therefore  contractual  distributions 
of  net  revenue.  Being  contractual  it  is  essential  that  the  accrual 
on  each  class  of  securities  be  kept  in  a  distinct  account.  In- 
terest on  first  mortgage  bonds,  for  example,  must  be  met  before 
any  net  revenue  is  apportioned  to  second  mortgage  bonds,  and 
interest  on  these  must  in  turn  be  met  before  a  further  appor- 
tionment to  the  less  secured  equities  such  as  income  bonds,  de- 
benture bonds,  etc.  Interest  on  each  class  of  security  therefore 
has  a  significance  of  its  own.  Further,  interest  received  from 
securities  owned  should  not  be  placed  in  the  same  accounts  with 
interest  on  outstanding  securities.  The  net  revenue  statement 
of  a  corporation  having  several  classes  of  securities  outstanding, 
for  example,  might  have  interest  accounts  as  shown  by  the 
following  statement. 

NET  REVENUE  STATEMENT 

Interest  on  First  Mtg.  Balance  from  Expense 

4's  $585,490         and  Revenue  $2,356,200 

Interest  on  Second  Mtg.  Interest  on  Securities 

S's  495,38o         Owned  15,365 

Interest  on  Income 
6's  298,300 

Interest  on  Debentures 

7's  185,275 

Balance 

(Stockholders' Equity)      807,120  • 

$2,371,565  $2,371,565 

The  order  of  the  interest  accounts  on  the  debit  side  is  of  con- 
siderable importance.  They  should  be  listed  in  the  order  of 
claims  to  net  revenue  as  specified  in  the  security  contracts. 
The  balance  carried  from  net  revenue  is  available,  after  taxes 
have  been  deducted,  for  the  private  equities.  Interest  on  first 
mortgages  must  of  course  be  met  before  the  second  mortgage 
bondholders  may  present  their  claims,  and  so  on ;  and  in  case  of 
a  deficiency  in  net  revenue  the  loss  of  interest  is  placed  on  the 
security  holders  whose  claims  are  placed  low  in  the  list.  This 
matter  can  always  be  definitely  settled  by  an  examination  of  the 
text  of  the  security  contract. 

The  determination  of  the  amount  to  be  entered  in  each  interest 
account,  however,  is  not  such  an  easy  matter.  The  fact  that  4  per 


ANALYSIS  OF  THE  INTEREST  PROBLEM  341 

cent  bonds  with  a  par  value  of  $1,000,000.00  are  outstanding  and 
that  $40,000.00  is  paid  over  to  the  bondholders  each  year  does  not 
necessarily  mean  that  $40,000.00  should  be  charged  to  the  ap- 
propriate bond  interest  account.  In  fact  the  charge  would  be 
equal  to  the  annual  payment  of  bond  interest  only  in  cases  which 
rarely  exist  in  actual  practice,  namely  in  case  the  bonds  are  sold 
at  par.  If  the  $1,000,000.00  issue  of  4  per  cent  bonds  due  in 
twenty  years  were  sold  to  investors  for  only  $934,516.19,  for 
example,  and  this  would  be  the  case  if  the  market  rate  of  interest 
were  4-^  per  cent,  the  interest  accrual  on  the  bonds  would  be 
greater  than  $40,000.00.  The  detailed  explanation  of  this  fact 
will  be  deferred  to  the  next  chapter  where  the  mathematical  com- 
putations are  given,  but  the  principle  involved  can  perhaps  be 
explained  in  a  few  words  at  this  point. 

In  the  preceding  section  two  illustrations  of  short-time  notes 
were  given.  In  the  second  one  a  non-interest  bearing  note  was 
discounted  at  a  bank.  It  was  said  that  this  discount  is  in  fact 
interest  that  accrues  in  the  ensuing  period  before  it  becomes 
due.  Now  even  if  the  note  had  been  interest  bearing  as  the  first 
one  was  but  the  amount  of  interest  were  not  as  much  as  the 
market  dictated  should  be  given,  the  note  would  again  be  dis- 
counted and  this  discount  would  be  part  of  the  interest.  The 
case  of  the  twenty-year  bonds  under  consideration  is  analogous 
to  this  situation.  The  main  difference  is  that  more  time  elapses 
between  the  date  of  issue  and  final  payment  and  that  the  interest 
on  the  bonds  is  paid  periodically  throughout  the  life  of  the  bonds. 
But  the  rate  of  interest  stated  in  the  bonds  is  not  as  high  as  the 
market  requires  for  this  type  of  security ;  therefore,  the  security 
will  be  discounted  and  the  discount  is  part  of  the  interest.  Fur- 
ther it  was  stated  in  the  preceding  section  that  after  the  interest 
had  accrued,  the  Discount  account  should  be  credited  and  In- 
terest charged,  but  that  inasmuch  as  the  period  involved  was 
short,  Interest  might  be  charged  in  the  original  entry.  In  the 
case  at  hand,  however,  Discount  on  Bonds  should  be  credited 
and  Interest  on  Bonds  charged  only  as  the  interest  accrues,  as 
the  interest  account  cannot  be  charged  directly  for  the  whole 
discount  at  the  date  of  issue  because  the  integrity  of  a  great 
many  succeeding  net  revenue  statements  is  at  stake.  At  the 
date  of  issue  then  entries  must  be  made  recognizing  this  discount. 


342  PRINCIPLES  OF  ACCOUNTING 

Cash $934,516.19 

Discount  on  Bonds      ....        65,483.81 

First  Mortgage  Bonds    .  $1,000,000.00 

The  Discount  on  Bonds  is  a  valuation  account  to  be  written  off 
as  the  interest  actually  accrues.  During  the  first  six  months, 
the  interest  accruing  would  amount  to  i\  per  cent  of  $934,516.19 
(if  interest  were  payable  semiannually,  see  next  chapter),  or 
$21,026.61.  At  this  time  bond  interest  to  the  amount  of 
$20,000.00  is  paid  on  this  accrual  so  this  payment  is  short  just 
$1,026.61.  Interest  on  Bonds  is  charged  with  the  total  ac- 
crual, Cash  credited  with  the  payment,  and  Discount  on  Bonds 
with  the  balance. 

Interest  on  Bonds $21,026.61 

Cash $20,000.00 

Discount  on  Bonds  ....  1,026.61 

When  this  $1,026.61  is  subtracted  from  $65,483.81  a  balance  is 
left  in  the  valuation  account,  Discount  on  Bonds,  of  only  $64,- 
457.20.  The  bondholders'  net  investment  then  is  $1,000,000.00 
less  $64,457.20  or  $935,542.80,  and  the  interest  accrual  for  the 
next  six  months  is  2^  per  cent  of  this  amount  or  $21,049.71. 
The  same  form  of  interest  entry  would  now  be  made  with  this 
amount  charged  to  interest.  The  total  interest  for  the  year 
then  is  $42,076.32  instead  of  $40,000.00,  the  amount  of  the  pay- 
ments. Continuing  this  policy  for  the  twenty  years  the  Interest 
on  Bonds  account  for  each  period  would  be  charged  with  its  due 
share  of  interest  and  the  Discount  on  Bonds  account  closed. 

On  the  other  hand  if  the  $1,000,000.00  of  bonds  had  carried  a 
5  per  cent  rate  and  were  sold  to  investors  on  a  4^  per  cent  market 
basis,  the  price  would  be  $1,065,483.81.  The  bonds  are  said  to 
be  sold  at  a  premium  of  $65,483.81.  This  premium  is  simply 
part  of  the  investment  which  is  returned  in  the  bond  interest 
payments.  In  this  case,  that  is,  the  interest  charge  for  each  year 
would  be  less  than  $50,000.00,  the  amount  of  the  payment. 
The  corporation  pays  $50,000.00  each  year,  but  this  is  more  than 
the  market  demands  in  the  form  of  interest,  therefore  the  in- 
vestor makes  a  payment  at  the  date  of  issue  for  the  privilege  of 
receiving  these  additional  sums.  The  corporation  at  the  date  of 
issue  makes  these  entries, 


ANALYSIS  OF  THE  INTEREST  PROBLEM  343 

Cash        $1,065,483.81 

First  Mortgage  Bonds  .  $1,000,000.00 

Premium  on  Bonds       .  65,483.81 

The  Premium  on  Bonds  account  represents  part  of  the  bond- 
holder's equity  and  will  remain  on  the  books  until  written  down 
at  subsequent  interest  payment  dates.  At  the  end  of  six  months, 
the  interest  accrual  on  the  market  rate  is  2-J  per  cent  of  the  orig- 
inal investment,  $1,065,483.81,  or  $23,973.39.  But  the  corpora- 
tion actually  pays  $25,000.00  in  bond  interest.  The  difference 
between  these  two  quantities  is  a  return  of  part  of  the  original 
investment  originally  credited  to  Premium  on  Bonds.  The 
entries  are, 

Interest  on  Bonds $23,973.39 

Premium  on  Bonds 1,026.61 

Cash $25,000.00 

The  investment  now  remaining  in  the  bonds  is  only  $1,064,- 
457.20  and  it  is  on  this  figure  that  interest  really  accrues  at  2% 
per  cent  for  the  next  six  months.  This  accrual  amounts  to  $23,- 
950.29  and  the  payment  of  $25,000.00  leaves  $1,049.71  as  another 
return  of  premium.  The  total  interest  charge  for  the  year,  there- 
fore, is  $47,923.68  instead  of  $50,000.00,  the  cash  payment.  The 
continued  use  of  this  method  for  the  twenty  years  would  reduce 
the  Premium  on  Bonds  account  to  zero  and  would  charge  the 
proper  amount  of  interest  against  each  year's  net  revenue  state- 
ment. 

Accumulation  of  discount  and  amortization  of  premium  tables 
may  easily  be  prepared  to  serve  as  a  basis  for  the  interest  entries 
for  bonds  at  a  discount  or  premium  respectively.  In  the  next 
chapter  a  rather  detailed  explanation  of  such  tables  is  given 
together  with  the  necessary  mathematical  formulae  for  bond 
valuations.  The  purpose  of  raising  the  question  at  this  point  is 
to  show  the  necessity  for  making  an  accurate  computation  of 
the  interest  item.  Obviously  an  error  in  stating  the  accrual  of 
interest  on  one  class  of  security  in  the  net  revenue  statement 
might  cause  an  unjust  distribution  to  other  classes  of  security 
holders.  Many  complicated  computations  arise  in  placing 
the  proper  figure  in  the  interest  accounts,  but  the  security  con- 
tracts must  be  carefully  investigated  together  with  the  quoted 


344  PRINCIPLES  OF  ACCOUNTING 

price  as  affected  by  the  market  conditions.  With  these  facts  at 
hand,  proper  entries  can  be  made  with  the  aid  of  mathematical 
computations  or  various  interest  tables  based  upon  the  same. 


INTEREST  IN  VALUATIONS 

The  fact  that  interest  enters  into  every  transaction  where 
time  is  an  element  is  of  particular  significance  in  the  valuation 
of  the  fixed  assets.  Ideally  there  is  a  rather  definite  relation 
between  the  revenue  attributable  to  an  asset  item  and  the  value 
of  that  item  at  any  time.  In  fact  if  the  revenue  is  definitely 
known  or  can  with  any  degree  of  accuracy  be  estimated,  the 
valuation  of  the  asset  even  for  sale  purposes  is  obtained  by  a  dis- 
counting process.  On  the  other  hand  where  there  is  no  reason- 
able basis  for  estimating  the  future  revenues  obtainable,  interest 
is  a  factor  which  must  be  taken  into  account  on  the  production 
side.  That  is,  interest  always  enters  into  the  situation  though 
sometimes  the  computation  is  made  by  looking  at  the  revenues 
and  applying  a  discounting  process,  while  at  other  times  the  com- 
putation is  made  by  looking  at  the  cost  or  investment  side  and 
applying  the  interest  computation  to  that  figure.  It  is  partially 
because  of  these  different  ways  of  looking  at  the  asset  items  that 
it  is  convenient  to  classify  the  fixed  assets  into  the  ordinary 
intangible  items,  tangible  items,  and  claims  against  others 
(securities).  A  brief  statement  of  the  way  in  which  interest 
enters  into  the  valuation  of  each  of  these  classes  of  assets  will  be 
made  in  this  section,  and  a  more  detailed  discussion  of  each  class 
will  be  found  in  later  chapters. 

The  valuation  of  securities  owned  presents  the  simplest  case 
as  the  purchaser  of  a  security  consciously  makes  his  bid  on  the 
basis  of  the  amounts  to  be  received  in  the  future.  The  future 
sums  due  are  all  definitely  stated  in  the  security  contract  (except 
in  the  case  of  capital  stock)  and  the  market  rate  of  interest  then 
determines  the  purchase  price.  The  reason  that  a  $1,000.00, 
twenty-year,  4  per  cent  bond  is  purchased  for  $934.52,  is  that  if 
the  market  rate  of  interest  is  4^  per  cent  this  sum  is  the  dis- 
counted value  of  all  the  amounts  which  the  bond  entitles  the 
purchaser  to  obtain.  The  entries  which  are  made  on  the  issuing 
company's  books  covering  such  situations  were  illustrated  in 


ANALYSIS  OF  THE  INTEREST  PROBLEM  345 

the  preceding  section,  and  the  purchaser  of  the  bond  is  simply 
looking  at  the  same  transaction  from  another  point  of  view.  In 
his  case  the  bond  is  an  asset  and  the  interest  actually  accruing 
on  the  bond  is  a  credit  to  net  revenue.  For  example,  at  the  time 
of  acquiring  the  bond  just  mentioned,  the  purchaser  would 
make  these  entries, 

Bonds  Owned l $934.52 

Cash $934-52 

At  the  end  of  six  months  when  the  $20.00  bond  interest  payment 
is  received  a  revaluation  of  the  bond  should  be  made.  The 
holder  now  owns  a  19^  year  bond  and  if  the  market  rate  is  still 
4!  per  cent  this  will  give  a  value  of  $935.54.  The  journal  entries 
are, 

Bonds  Owned $  1.02 

Cash 20.00 

Interest  on  Bonds  Owned    ....  $21.02 

The  interest  earning  consists  of  an  increment  in  the  value  of  the 
bond  owned  of  $1.02  plus  the  $20.00  cash  received  from  the  cor- 
poration. If  the  bond  had  decreased  in  value  instead  of  increas- 
ing the  entries  would  have  shown  credits  to  the  Bonds  Owned 
account  and  to  Interest  equal  to  the  debit  to  Cash.  Changes 
in  value  either  way  are  caused  by  a  change  in  the  present  value 
of  the  sums  due  in  the  future.  In  Chapter  XVIII  the  details 
of  the  valuation  of  securities  on  the  books  of  the  purchaser  are 
explained.  Enough  has  been  said  here  to  show  that  in  the  case 
of  securities  owned  interest  is  an  important  factor  in  valua- 
tion, and  to  show  the  necessity  for  a  knowledge  of  the  mathe- 
matics of  interest  calculations  in  this  connection. 

In  the  valuation  of  the  general  class  of  intangible  assets  such 
as  goodwill,  franchises,  patents,  leases,  etc.,  the  discounting 
process  is  used.  In  some  of  these  cases  the  amounts  of  revenue 
to  be  received  due  to  the  existence  of  the  property  right  are  def- 
initely known.  The  valuation  in  such  cases  follows  the  same  pro- 
cedure as  for  securities.  The  value  of  the  lease-hold  which  brings 

1  There  is  something  to  be  said  in  favor  of  listing  the  bonds  owned  in  this  account 
at  par  and  using  a  valuation  account  Discount  on  Bonds  Owned  as  an  offset.  For  the 
purpose  of  this  illustration,  however,  the  net  valuation  may  properly  be  carried  into 
the  Bonds  Owned  account. 


346  PRINCIPLES  OF  ACCOUNTING 

in  $10,000.00  per  year  but  which  expires  at  the  end  of  fifteen 
years  is,  if  the  market  rate  of  interest  for  such  an  investment  is 
6  per  cent,  $97, 1 2  2. 49.  This  figure  represents  the  discounted  value 
of  the  fifteen  payments  of  $10,000.00  each  on  a  6  per  cent  interest 
basis.  Further  this  would  be  the  sale  price  if  it  were  placed  on 
the  market  with  the  buyer  and  seller  having  the  same  informa- 
tion. In  the  case  of  other  intangibles  where  the  definite  amount 
of  revenue  to  be  obtained  is  unknown,  the  revenue  items  are 
estimated.  In  the  valuation  of  goodwill,  for  example,  a  judg- 
ment is  made  of  the  amount  of  revenue  attributable  to  this 
factor  and  the  number  of  years  it  will  be  effective.  With  this 
estimate  as  a  basis,  the  value  is  obtained  through  the  discounting 
process.  The  same  may  be  said  of  franchise  values  and  of  all 
intangibles  when  the  revenue  is  fixed  by  contract  or  otherwise 
definitely  known. 

There  are  many  practical  questions  which  arise  in  the  valuation 
of  intangibles,  and  which  must  be  settled  before  the  discount 
process  is  employed,  and  these  will  be  taken  up  quite  fully  in 
Chapter  XXIV.  In  all  these  cases,  however,  after  the  revenue 
figures  have  been  obtained,  either  by  definite  contract  or  estimate, 
the  interest  calculation  is  the  final  determining  factor. 

In  the  case  of  tangible  assets,  the  case  for  interest  is  not  quite 
so  clear.  Here  it  may  be  said  with  reason  that  the  original  val- 
uation at  the  date  of  purchase  at  least  is  not  immediately  de- 
pendent upon  the  revenue  attributable  to  the  item.  The  man- 
ager of  a  factory  decides  that  in  view  of  the  conditions  in  his 
plant,  the  labor  market  and  all  other  factors  to  be  considered, 
it  would  pay  him  to  invest  in  a  certain  machine.  He  pays  just 
$15,000.00  for  the  machine  desired,  not  because  that  figure  rep- 
resents the  present  value  of  the  revenues  attributable  to  the 
machine  but  because  the  market  price  of  that  machine  at  that 
time  is  $15,000.00.  He  might  be  willing  to  pay  more  but  this 
is  unnecessary  so  long  as  it  can  be  obtained  on  the  market  for 
that  price.  Of  course,  he  would  have  convinced  himself  that 
the  machine  was  capable  of  aiding  sufficiently  in  the  production 
of  his  product  to  yield  a  net  return  at  least  equal  to  the  market 
rate  of  interest  in  addition  to  replacing  the  original  investment, 
but  the  final  definite  basis  for  the  original  valuation  in  each  in- 
dividual purchase  is  the  market  price  of  the  item  purchased. 


ANALYSIS  OF  THE  INTEREST  PROBLEM  347 

Here  the  asset  is  being  viewed  from  a  different  standpoint  than 
that  applicable  to  intangibles.  Cost,  or  at  least  the  market  price 
of  the  specific  item  as  viewed  from  the  cost  side,  seems  to  be 
decisive.  How  then  does  the  interest  problem  enter  into  this 
situation?  This  is  a  much  mooted  question  in  connection  with 
valuation  in  general  and  requires  some  care  in  answering. 

One  purpose  in  revaluing  physical  property  items  is,  as  it  is 
for  any  asset,  to  restate  the  book  value  and  make  it  correspond 
to  the  present  value.  Now  in  the  assets  comprising  the  other 
classes,  i.e.  intangibles  and  securities,  the  market  can  be  relied 
upon  to  furnish  the  information.  That  is,  a  rather  definite 
figure  can  be  obtained  for  valuation  purposes  on  the  basis  of  mar- 
ket information.  This  figure  is  obtained,  as  was  stated  in  the 
discussion  above,  through  the  use  of  the  market  rate  of  interest 
in  discounting  revenues  which  are  known. 

The  market  is  not  available,  however,  for  this  purpose  in  the 
revaluation  of  the  ordinary  tangible  assets.  The  revenues  are 
uncertain  to  say  the  least  and  a  discounting  process  cannot  be 
used.  Since  cost  is  the  basis  of  the  original  valuation,  it  is  but 
natural  to  expect  future  valuations  of  the  same  asset  to  be  in  some 
way  based  on  cost,  but  the  market  cannot  be  relied  upon  here, 
either,  as  there  is  no  market  for  second-hand  machinery,  build- 
ings, and  the  like  which  can  be  used  for  valuing  such  items  in 
use.  The  estimate  or  appraisal  of  the  engineer  is,  therefore, 
substituted  for  the  market  test,  and  this  practice  has  given  rise 
to  the  basis  of  valuation  on  cost  of  reproduction  less  deprecia- 
tion or,  in  some  cases,  original  cost  less  depreciation.  That  is,  a 
judgment  as  to  cost  and  accrued  depreciation  is  substituted  for 
a  market  test. 

The  judgment  of  the  engineer  or  of  the  manager  cannot  be 
relied  upon  to  furnish  accurate  measurements  of  depreciation 
on  the  basis  of  inspection  or  mere  physical  measurement.  A  pair 
of  calipers  cannot  be  used  for  measuring  the  extent  to  which  a 
machine  which  is  still  being  operated  in  its  entirety  has  depreci- 
ated. Physical  measurements  can  be  used  for  revising  estimates 
of  the  probable  service  life,  but  value  expiration  cannot  be  ob- 
tained in  such  a  way.  The  only  way  left  open  for  making  such 
revaluations  is  by  spreading  the  depreciation  charge  in  the  ex- 
pense accounts  over  the  life  of  the  property  item.  At  any  time 


348  PRINCIPLES  OF  ACCOUNTING 

the  book  value  is  the  difference  between  the  original  cost  and  the 
amount  charged  to  expense  for  depreciation. 

It  is  not  the  purpose  of  this  chapter  to  discuss  the  methods  of 
measuring  depreciation  and  the  resultant  valuing  of  tangible 
property  on  this  basis.  This  question  is  discussed  in  Chapter 
XXIII.  Enough  will  have  been  said  here  by  mentioning  the 
fact  that  in  the  more  approved  methods  of  accounting  for  de- 
preciation interest  is  usually  considered  as  a  factor.  At  least  in 
the  sinking  fund,  compound  interest,  and  annuity  methods,  in- 
terest is  indeed  one  of  the  most  important  factors.  These 
methods  all  recognize  to  some  extent  at  least  that  interest  is  an 
element  which  must  be  shown  in  the  accounts  wherever  a  durable 
property  item  is  used.  The  methods  by  which  this  factor  is 
brought  into  the  calculation  are  highly  technical  and  hence  can- 
not be  discussed  without  a  considerable  knowledge  of  interest 
computations  such  as  are  given  in  the  next  chapter. 

Finally,  it  may  be  said,  in  summarizing  this  discussion,  that 
interest  calculations  enter  into  the  accounting  computations  at 
some  point  or  other  in  every  case  where  time  is  an  important 
element  in  the  process  of  production.  In  some  cases  it  enters 
as  an  explicit  payment  for  the  service  rendered  based  on  con- 
tract. In  other  cases  there  is  no  explicit  recognition  by  con- 
tract but  it  is  involved  in  a  discounting  process.  Again  it  may 
enter  as  an  addition  to  or  adjustment  of  cost  figures  for  purposes 
of  valuation.  In  fact  so  important  is  the  question  that  the  next 
chapter  will  be  given  over  entirely  to  the  technical  computations 
which  comnionly  present  themselves. 


XVI 

INTEREST  CALCULATIONS 

THERE  are  several  reasons  for  a  rather  detailed  discussion  of 
the  formulae  which  are  most  frequently  needed  in  the  solution 
of  accounting  problems  involving  interest.  It  cannot  safely 
be  assumed  that  the  student  of  accounting  either  remembers  or 
understands  the  fundamental  interest  situations  treated  in  the 
ordinary  arithmetic.  Moreover  interest  computations  may  be 
very  complicated,  as  in  the  case  of  the  determination  of  principal 
and  interest  in  connection  with  such  securities  as  bonds ;  and 
the  accountant  who  is  to  be  thoroughly  at  home  in  dealing  with 
theories  must  be  thoroughly  competent  to  deal  with  the  mathe- 
matical principles  involved. 

Bond  interest  payments,  annuity  installments,  sinking  fund 
contributions,  and  many  other  similar  items  can  be  properly 
entered  in  the  accounts  only  on  the  basis  of  mathematical 
computations.  Similarly,  as  was  stated  in  the  last  chapter, 
interest  calculations  are  necessary  in  connection  with  the  valua- 
tion of  certain  classes  of  property  such  as  leases,  patents,  and 
other  wasting  assets  and  are  involved  in  certain  general  methods 
of  estimating  depreciation.  The  fact  that  these  situations  arise 
is  therefore  ample  justification  for  a  rather  lengthy  discussion  of 
the  mathematics  of  interest  computations.  In  fact  so  important 
are  these  calculations  that  it  has  seemed  best  to  defer  to  the  next 
two  chapters  the  discussion  of  purely  accounting  aspects  of  the 
situations  involving  the  use  of  these  formulae  in  order  that  this 
chapter  might  be  confined  to  the  explicit  mathematics  of  in- 
terest. 

THE  ACCUMULATION   OF   PRINCIPAL 

Perhaps  the  computation  used  most  frequently  in  business 
transactions  is  that  of  determining  the  amount  to  which  a  prin- 
cipal will  accumulate  in  a  given  period  at  a  certain  rate  of  in- 
terest. While  most  of  such  computations  are  made  at  c&mpound 

349 


350 


PRINCIPLES  OF  ACCOUNTING 


interest  rates,  the  fact  that  occasionally  a  contract  is  made  at 
the  simple  rate  makes  necessary  an  analysis  of  the  two  kinds  of 
computations.  At  the  risk  of  attempting  to  explain  the  obvious, 
therefore,  the  following  elementary  definitions  are  given  as  a 
basis  for  the  discussion  in  this  and  succeeding  sections  of  the 
present  chapter. 

The  unit  of  time  used  in  interest  calculations  is  the  year.  The 
total  interest  accruing  on  one  unit  of  principal  (the  dollar]  in  one 
year  is  the  rate  of  interest.  Compound  interest  results  from  adding 
interest  to  the  principal  at  stated  intervals,  and  allowing  interest 
to  accrue  on  the  sum  for  the  succeeding  periods.  Simple  interest 
accrues  if  no  interest  is  added  to  the  principal  in  this  manner. 
The  number  of  periods  per  year  at  which  interest  is  added  to  the 
principal  for  compounding  is  called  the  frequency  of  conversion. 

If  a  principal  of  $100.00  were  invested  at  6  per  cent  simple 
interest  for  five  years,  it  would  accumulate  according  to  definition 
as  shown  by  the  following  table. 


(I) 

(2) 

(3) 

(4) 

YEAR 

PRINCIPAL  ON  WHICH 
INTEREST  is  COMPUTED 

INTEREST  DURING  YEAR 

SUM  AT  END  OF  YEAR 

I 

$IOO.OO 

$6.00 

$106.00 

2 

IOO.OO 

6.00 

112.  CO 

2 

100.00 

6.00 

118.00 

4 

IOO.OO 

6.00 

124.00 

5 

100.00 

6.00 

130.00 

The  total  interest  for  the  five  years  is  five  times  the  interest  for 
one  year  or  $30.00.  A  formula  may  easily  be  developed  on  the 
basis  of  such  a  schedule.  Using  the  symbol  P  to  represent  the 
principal ;  S,  the  sum  to  which  the  principal  will  accumulate ; 
i,  the  rate  of  interest ;  and  n,  the  number  of  years ;  the  following 
equation  is  evidently  true, 

5  =  P  +  Pni 
or, 


(i)1 


S=P(i  +  ni) 


1  The  more  important  formulae  will  be  numbered  in  order  that  reference  may 
easily  be  made  to  them. 


INTEREST   CALCULATIONS 


351 


This  is  the  standard  equation  for  the  accumulation  of  a  principal 
at  simple  interest. 

Thus,  in  the  above  illustration,  P  is  $100.00 ;  n,  5  ;  and  i,  .06 
(or  6  per  cent).  The  substitution  of  these  quantities  in  formula 
(i)  gives  the  following, 

5  =  100(1  +  .30) 
=  130.00 

If,  now,  a  principal  of  $100.00  were  invested  at  6  per  cent  com- 
pound interest  convertible  annually,  the  corresponding  amounts 
would  be  as  follows  : 


(I) 

(2) 

(3) 

(4) 

YEAR 

PRINCIPAL  ON  WHICH 
INTEREST  is  COMPUTED 

INTEREST  DURING  YEAR 

SUM  AT  END  OF  YEAR 

I 

$100.00 

$6.00 

$106.00 

2 

IO6.OO 

6.36 

112.36 

3 

112.36 

6.74 

IIQ.IO 

4 

IIQ.IO 

7-15 

126.25 

5 

126.25 

7-57 

133.82 

The  formula  which  expresses  the  accumulation  for  one  year  is 
the  same  in  this  case  as  for  simple  interest  because  the  compound- 
ing process  is  not  performed  until  the  end  of  the  first  year.  There- 
fore the  formula  for  the  first  year  is  S  =  P(i  +  i}  (from  formula 
(i)  when  n  is  i).  Now  the  sum  for  the  second  year  is  obtained 
in  a  like  manner  except  that  the  principal  at  the  beginning  of 
this  year  is  the  sum  from  the  preceding  year.  Then  5  = 
P(i  +  i)(i  +  *')  =  P(i  +  i)z-  Again,  the  sum  at  the  end  of  the 
third  year  would  be  equivalent  to  P(i  +  *)2(i  +  i},  or  P(i  +  *)3- 
Generalizing  from  this  reasoning  it  may  easily  be  seen  that  the 
sum  to  which  the  principal  P  would  accumulate  in  n  years  would 
be  expressed  by  the  formula, 


This  formula  may  be  used  for  finding  the  amount  to  which  a 
principal  will  accumulate  in  any  number  of  years  at  a  given  rate 


352  PRINCIPLES  OF  ACCOUNTING 

of  interest,  convertible  annually.  Thus,  in  the  illustration  just 
given,  the  principal  (P)  is  100,  the  interest  (i)  is  .06,  and  the 
number  of  years  (w)  is  5.  Substituting  these  figures  in  equation 

(2)  gives, 

S  =  ioo(i.o6)6 
=  133-82 

which  is  the  same  result  as  shown  by  the  table. 

The  term  (i  +  i)n  in  the  right-hand  member  of  equation  (2) 
expresses  the  accumulation  of  one  dollar  at  rate  i  for  n  years. 
This  can  be  shown  very  clearly  by  assuming  that  the  principal 
(P)  is  one.  The  formula  then  becomes, 

(3)  S  =  (i  +  *')» 

Now  this  expression  contains  but  two  variables,  i  and  n,  which 
makes  it  very  convenient  to  construct  a  table  for  values  of  S. 
Such  a  table  is  of  a  great  deal  of  service  in  finding  the  accumula- 
tion of  principal  sums  since  the  S  in  equation  (3)  multiplied  by 
the  principal  gives  the  value  of  S  in  equation  (2).  For  an  il- 
lustration of  such  a  table  see  Table  I  in  Appendix  B.  Here  the 
different  rates  of  interest  are  shown  at  the  heads  of  the  various 
columns  while  the  numbers  of  years  are  shown  in  the  columns  at 
the  sides  of  the  page.  Thus  to  find  the  accumulation  of  one  dol- 
lar at  6  per  cent  convertible  annually  for  five  years  refer  to  the 
column  headed  "6  %"  and  opposite  the  figure  5  in  the  column 
headed  "n."  The  required  quantity  is  1.3382256,  the  value  of 
5  in  equation  (3)  for  the  conditions  assumed.  Now  if  the  prin- 
cipal were  $100.00,  the  sum  could  be  found  by  substituting  for 
(i  -f-  i)n  in  formula  (2),  the  quantity  found  in  the  table. 

.  S  =  100(1.3382256) 
=  133-82 

This  result  is  identical  with  the  accumulations  shown  in  the  two 
preceding  computations.  The  saving  in  computation  effected 
through  the  use  of  the  interest  tables  is  evident.  Of  course 
whenever  a  computation  involves  a  rate  of  interest  not  given 
in  the  tables  equation  (2)  must  be  solved  in  detail. 

Interest  is  compounded  more  frequently  than  once  a  year  in  a 
great  many  transactions.  The  accumulation  of  a  principal  in 


INTEREST  CALCULATIONS 


353 


such  cases  is  illustrated  in  the  following  table  which  shows  the 
accumulation  of  $100.00  for  five  years  at  6  per  cent,  interest  con- 
vertible semiannually. 


(I) 

(2) 

(3) 

(4) 

PERIOD 

PRINCIPAL  AT  BEGIN- 
NING OF  PERIOD 

INTEREST  DURING 
PERIOD 

SUM  AT  END  OF  PERIOD 

I 

$IOO.OO 

$3.00 

$103.00 

2 

103.00 

3-°9 

106.09 

3 

106.09 

3-18 

109.27 

4 

109.27 

3-28 

112.55 

5 

112.55 

3.38 

U5-93 

6 

H5-93 

348 

119.41 

7 

119.41 

3-58 

122.99 

8 

122.99 

3-69 

126.68 

9 

126.68 

3-8o 

130.48 

10 

130.48 

3-91 

134-39 

It  is  evident  from  this  table  that  if  the  half-year  period  is  taken 
as  the  unit  of  time,  the  rate  per  period  as  the  interest  rate,  and 
the  number  of  periods  as  twice  the  number  of  years,  in  place  of 
the  year,  rate  per  year,  and  number  of  years  respectively,  the 
sum  accumulates  in  conformity  with  equation  (2).  If  the  stated 
annual  rate  is  represented  by  j,  and  the  frequency  of  conversion 
by  m,  then  the  rate  per  period  would  bej/m,  and  the  number  of 
periods,  mn.  The  formula  for  the  accumulation  in  this  case 
would  therefore  be, 

(4)  S  =  P(i  +  Jim)™ 

To  illustrate  the  use  of  this  equation,  consider  the  principal 
as  $100.00,  the  nominal  rate  of  interest  as  6  per  cent  convertible 
semiannually,  and  the  period  of  accumulation  as  five  years. 
The  substitution  of  these  quantities  in  equation  (4)  gives  the 
following, 


c             f    _!_  -o6Y0 
S  =  ioo(  i  H ) 

V  -2  / 


=  134.39, 

the  same  result  as  was  obtained  in  the  table  shown  above. 

Table  I  in  Appendix  B  can  also  be  used  as  an  aid  in  solving 


2  A 


354  PRINCIPLES  OF  ACCOUNTING 

equation  (4).  This  is  evident  by  an  inspection  of  the  term 
(i  +y/w)mn,  which  is  the  same  in  form  as  the  term  (i  +  i)n  in 
equation  (3).  Thus  when  the  nominal  rate  is  6  per  cent  convert- 
ible semiannually  for  five  years,  the  expression  (i  -\-  j/m)mn  be- 
comes (i  +  .O3)10.  Now  for  convenience  in  computation,  3  per 
cent  can  be  considered  as  the  rate  and  that  column  referred  to  in 
the  table.  Further,  10  can  be  considered  as  the  number  of  periods 
as  shown  in  the  column  headed  "«."  The  amount  opposite  10 
in  the  3  per  cent  column,  1.3439164,  is  the  value  of  the  expression 
(i  +  j/m)mn  in  the  case  assumed.  This  quantity  substituted  in 
the  original  equation  gives, 

S  =  100(1.3439164) 
=  134-39 

When  interest  is  converted  more  frequently  than  once  a  year, 
the  stated  rate  without  compounding  is  called  the  nominal  rate, 
while  the  rate  actually  realized  in  one  year  is  called  the  effective 
rate  of  interest:  In  the  illustration  above,  for  example,  the 
nominal  rate  is  6  per  cent  convertible  semiannually.  The  ef- 
fective rate  may  readily  be  found  by  dividing  the  total  interest 
accruing  in  the  year,  $6.09,  by  the  principal  at  the  beginning, 
$100.00,  which  gives  6.09  per  cent.  A  mathematical  expression 
for  the  relation  between  the  effective  and  nominal  rates  may 
easily  be  obtained  from  the  definition  given.  Thus  the  amount 
to  which  one  dollar  will  accumulate  in  one  year  at  the  nominal 
rate/  is  (i  -f-  j/m)m.  The  total  interest  earned  is  (i  +  j/m)m  —  i. 
But  the  total  interest  on  one  dollar  in  one  year  is  the  effective 
rate,  therefore, 

(5)  i  =  (i  +j/ni)m-  i 

In  the  problem  just  given,  where  the  nominal  rate  was  6  per  cent 
convertible  semiannually,  the  effective  rate  may  be  found  by 

this  formula, 

(     i    -°6v 
*  =  I  i  H )  -  i 

V  2   J 

=  .0609  or  6.09  % 

The  converse  of  this  problem,  that  is  the  determination  of  the 
nominal  rate  which  will  produce  a  given  effective  rate,  may  be 
solved  from  formula  (5).  In  this  case  i  and  m  are  known,  but/ 


INTEREST  CALCULATIONS  355 

is  the  quantity  to  be  found.  Solving  equation  (5)  iorj,  the  result 
is, 

(6)  j  =  m{(i  +  i)l/m-  1} 

Thus  if  it  is  desired  to  extend  a  loan  at  an  effective  rate  of  6  per 
cent,  and  the  interest  is  to  be  converted  semiannually,  the  nom- 
inal rate  which  should  be  employed  may  be  found  from  equation 

7=  2{(i.o6)»-  i}=  5-96% 

THE  PRESENT  VALUE  OF  A  FUTURE  SUM 

In  the  preceding  section,  formulae  were  developed  which  ex- 
press the  accumulation  of  a  principal  at  simple  interest,  at  com- 
pound interest  convertible  annually,  and  at  compound  interest 
convertible  m  times  a  year.  The  converse  of  each  of  these  prob- 
lems very  frequently  arises  in  commercial  practice.  Stated  in 
general  terms  the  problem  is  to  find  the  present  value  of  a  definite 
sum  known  to  be  due  at  a  definite  date  in  the  future.  Such  a 
sum  may  be  discounted  with  the  use  of  a  discount  rate  or  with  an 
interest  rate,  either  of  which  computations  gives  a  different  re- 
sult. To  bring  out  the  points  of  difference,  both  methods  will 
be  illustrated  in  this  section. 

When  a  deduction  is  made  from  a  sum  due  at  a  future  date  to 
determine  the  present  value,  the  amount  deducted  is  called  dis- 
count, and  the  process  is  called  discounting.  The  amount  de- 
ducted is  in  fact  interest,  however,  and  this  fact  should  be  kept 
clearly  in  mind.  The  difference  between  the  present  value  and 
the  future  sum  is  interest  even  though  the  computation  is  made 
on  the  basis  of  a  future  sum.  Viewed  either  from  the  standpoint 
of  the  borrower  or  the  lender,  discount  may  be  defined  as  the 
consideration  for  the  use  of  the  present  value  (principal).  The 
total  discount  on  one  dollar  of  the  sum  due  in  one  year  is  the  rate 
of  discount. 

The  formula  for  finding  the  present  value  of  a  future  sum  at 
simple  discount  may  be  developed  directly  from  the  definition. 
Thus,  if  P  represents  the  present  value,  S,  the  sum  due,  n,  the 
number  of  years,  and  d,  the  rate  of  discount,  then 

P  =  S  -  Snd    or 

(7)  P  =  S(i  -  nd] 


356 


PRINCIPLES  OF  ACCOUNTING 


For  example,  if  a  sum  of  $100.00  due  in  five  years  were  discounted 
at  the  rate  of  6  per  cent  simple  discount,  the  present  value  would 
be  $100(1  —  .30)  or  $70.00.  The  rate  of  simple  discount  is  com- 
monly used  in  banking  transactions  for  short-time  loans,  such  as 
thirty,  sixty  and  ninety-day  paper ;  but  it  is  very  seldom  used 
for  transactions  covering  a  period  of  more  than  one  year. 

Compound  discount  is  only  of  theoretical  interest  as  it  would 
practically  never  be  used  in  actual  practice.  The  reason  for  this 
is  evident.  In  compound  discount  the  discount  is  deducted 
from  the  sum  due  at  stated  intervals  and  the  rate  is  applied  to 
the  remaining  sum ;  and  since  the  rate  would  be  applied  to  a 
continually  decreasing  sum  this  would  result  in  a  smaller  total 
discount  than  would  be  found  by  the  application  of  the  simple 
rate.  The  total  interest  involved  in  the  transaction  would  there- 
fore be  less  with  compound  than  with  simple  discount.  This 
may  be  made  still  more  evident  by  reference  to  the  following 
table  which  shows  the  compound  discount  on  a  sum  of  $100.00 
due  in  five  years  at  6  per  cent  discount,  convertible  annually. 


(I) 

(2) 

(3) 

(4) 

YEAR 

SUM  DUE  AT  END  OF 
YEAR 

DISCOUNT  FOR  YEAR 

PRESENT  VALUE  AT 
BEGINNING  OF  YEAR 

5 

$IOO.OO 

$6.00 

$94.00 

4 

94.00 

5-64 

88.36 

3 

88.36 

5-30 

83.06 

2 

83.06 

4.98 

78.08 

I 

78.08 

4.68 

73-40 

The  present  value  of  the  sum  in  this  case  is  $73.40  as  compared 
with  $70.00  when  the  simple  rate  is  used. 

The  equation  for  compound  discount  may  be  developed  directly 
on  the  basis  of  the  table  shown  above.  Using  the  same  symbols 
as  before,  the  present  value  at  the  beginning  of  the  nth  year  would 
be,  by  equation  (7),  P  =  S(i  —  d).  The  present  value  at  the 
beginning  of  the  year  (n  —  i)  would  be  found  in  the  same  manner 
(substituting  5(i  —  d)  for  S  in  formula  (7))  to  be, 


P  =  S(i  - 


-  d)=S(i  - 


INTEREST   CALCULATIONS 


357 


At  the  beginning  of  the  year  (n  —  2)  the  present  value  would 
be,  S(i  —  d)3,  found  in  the  same  manner.  The  formula  for 
the  present  value  at  the  beginning  of  the  first  year  would 
therefore  be, 

(8)  P  =  S(i  -  d}» 

Substituting  the  quantities  from  the  table  above, 

P  =  100(1  -  .o6)5 
=  73-40 

Instead  of  applying  the  compound  rate  of  discount  to  a  sum 
due,  it  is  customary  to  discount  the  sum  at  a  given  rate  of  interest. 
The  question  asked  in  such  cases  is,  "what  present  sum  will 
accumulate  at  a  given  rate  of  interest  to  the  sum  due  in  the 
future?"  When  this  question  is  asked  the  sum  in  the  future  is 
known  and  so  is  the  rate  of  interest  to  be  realized,  but  the  present 
value  is  unknown.  That  there  is  a  relation  between  the  rates  of 
discount  and  interest  which  is  capable  of  mathematical  expres- 
sion is  evident.  The  total  discount  on  the  sum  due  is  the  total 
interest  on  the  present  value,  but  the  rate  of  discount  in  a  given 
case  is  not  equal  to  the  rate  of  interest.  For  example,  if  $100.00 
due  one  year  from  date  were  discounted  at  6  per  cent,  the  discount 
would  be  $6.00,  and  the  present  value,  $94.00.  The  difference 
between  the  present  value  and  the  sum  due  is  interest.  Consid- 
ering the  present  value,  $94.00,  as  the  principal  now,  and  $6.00  as 
the  interest,  the  rate  of  interest  is  obviously  6/94  or  6.38  per  cent. 
In  other  words,  a  6  per  cent  rate  of  discount  produces  a  6.38 
per  cent  rate  of  interest  on  the  present  value. 

The  relation  between  the  rates  of  discount  and  interest  in  a 
given  transaction  is  of  sufficient  importance  to  be  expressed  in 
equation  form.  The  problem  may  be  stated  in  this  form,  what 
rate  of  discount  applied  to  a  sum  due  will  produce  such  a  present 
value  that  a  given  rate  of  interest  will  be  realized  on  the  present 
value?  Equations  (2)  and  (8)  may  be  solved  as  simultaneous 
equations  for  this  problem,  since  by  hypothesis  the  terms  P  and 
S  must  be  the  same  in  each  case.  Therefore,  from  equation  (2), 

S/P  =  (i  +  iY  and,  from  equation  (8),  S/P  --'         — .    Then 

(i  —  d)n 


358  PRINCIPLES  OF  ACCOUNTING 

(i  +  i)n  =  —  ,  and  solving  this  gives, 

(9)  rf=i--^. 

i  +  i 

If  it  is  desired  to  determine  the  compound  rate  of  discount 
which,  when  applied  to  a  sum  due,  will  produce  a  6  per  cent  rate 
of  interest  convertible  annually  on  the  present  value,  this  equa- 
tion is  of  service,  for  example, 


i  +  .06 
=  .0566  or  5.66  % 

On  the  other  hand  if  the  rate  of  discount  applied  to  a  sum  due  is 
6  per  cent,  and  it  is  desired  to  find  the  rate  of  interest  realized, 
equation  (9)  can  be  solved  for  i  and  the  substitutions  made. 

(10)  i  = i 

i  -  d 


—  i 


i  —  .06 
=  .0638  or  6.38  % 

Equation  (9)  is  by  far  the  more  important  for  practical  pur- 
poses. A  sum  may  be  discounted  very  readily  at  a  given  rate 
of  interest  by  use  of  this  formula.  Thus  if  the  value  of  d  in  this 
formula  is  substituted  for  d  in  formula  (8), 


which,  when  simplified,  becomes, 
(u)  P  =  S 


d  +  *)" 


To  illustrate,  if  a  sum  of  $100.00  due  in  five  years  is  discounted 
in  order  to  realize  a  6  per  cent  rate  of  interest  convertible  annually 
on  the  present  value,  then  from  equation  (n), 

P  =  100 

(i  +  .o6)5 

=  74-73 


INTEREST   CALCULATIONS  359 

That  is,  if  $74.73  were  invested  to-day  and  $100.00  were  received 
in  return  at  the  end  of  five  years,  the  investor  would  realize  6  per 
cent  interest  convertible  annually  on  his  investment. 

Referring  once  more  to  formula  (n),  it  may  be  seen  that  when 
the  sum  Shi,  the  equation  becomes, 

(12) 


(i  +  iy 

The  right-hand  side  of  this  equation  is  the  reciprocal  of  the  right 
side  of  formula  (3).  In  other  words,  the  present  value  of  one 
dollar  in  n  years  at  rate  i  is  the  reciprocal  of  the  accumulation 
of  one  dollar  at  rate  i  for  n  years.  If  a  table  of  values  for  formula 
(3)  is  available,  the  corresponding  value  for  formula  (12)  may  be 
found  by  the  process  of  simple  division.  Table  II  in  Appendix 
B  gives  the  values  of  P  in  equation  (12)  for  several  different 
rates  of  interest  and  for  periods  ranging  from  one  to  fifty.  The 
use  of  this  table  may  be  conveniently  illustrated  by  assuming 
that  it  is  desired  to  find  the  present  value  of  $100.00  due  in  five 
years  at  6  per  cent  interest  convertible  annually.  Referring  to 
the  column  headed  6  per  cent,  the  quantity  .7472582  is  found  op- 
posite the  fifth  period.  This  is  the  present  value  of  $1.00  due  in 
five  years,  and  the  present  value  of  $100.00  is  of  course  one  hun- 
dred times  this  quantity,  or  $74.73.  Or  the  result  may  be  found 
by  substituting  the  quantity  found  in  the  table  in  formula  (n). 

P  =  ioo(.7472582) 
=  74-73 

Formula  (n)  gives  the  present  value  when  interest  is  convert- 
ible annually.  In  order  to  find  an  equation  to  express  the  pres- 
ent value  when  interest  is  converted  more  frequently  than  once 
each  year,  it  is  only  necessary  to  substitute  for  i  in  this  equation 
its  equivalent  in  terms  of  j  and  m  from  formula  (5).  This  gives, 

d3)  P  = 


(i  H- //«)"•" 

Thus  if  the  $100.00  sum  mentioned  in  the  preceding  illustration 
were  discounted  at  the  nominal  rate  of  6  per  cent  convertible  semi- 
annually,  the  present  value  could  be  found  from  the  equation, 


360 


PRINCIPLES  OF  ACCOUNTING 


P  =  100 


(l  +  .06/2)10 

The  last  term  in  this  expression  can  be  found  in  Table  II  in  the 
3  percent  column  opposite  the  tenth  period  (.7440939).  There- 
fore, 

P  =  10007440939) 
=  74.41 

If  a  sum  of  $74.41  were  placed  in  a  fund  to  accumulate  at  6  per 
cent,  convertible  semiannually  for  five  years,  it  would  amount  to 
$100.00  at  the  end  of  the  period. 


THE   ACCUMULATION   OF   AN  ANNUITY 

In  the  section  before  last,  formulae  were  developed  which  ex- 
press the  accumulation  of  a  principal  at  compound  interest.  It 
is  the  purpose  in  this  section  to  present  the  formulas  for  expressing 
the  accumulation  of  an  annuity.  An  annuity  may  be  denned 
as  a  series  of  payments  made  at  equal  intervals  during  a  length 
of  time  specified  by  contract.  Each  payment,  for  the  purposes 
of  the  immediate  problem,  may  be  considered  as  a  principal 
which  accumulates  at  the  given  rate  of  interest  to  the  end  of  the 
life  of  the  annuity.  Each  payment  will,  therefore,  accumulate 
in  conformity  with  the  equation  for  the  accumulation  of  a  prin- 
cipal sum.  For  example,  if  an  annuity  of  $100.00  per  year  pay- 
able at  the  end  of  each  year  accumulates  at  the  rate  of  6  per 
cent  convertible  annually  for  five  years,  to  what  sum  does  it 
accumulate?'  The  following  table  shows  the  situation  and  gives 
the  answer  to  the  question. 


YEAR 

PAYMENT  AT  END  OP  YEAR 

ACCUJHJLATION  TO  END  OF 

STH  YEAR 

I 

$IOO.OO 

$126.25 

2 

IOO.OO 

IIQ.  10 

3 

100.00 

112.36 

4 

IOO.OO 

106.00 

5 

IOO.OO 

IOO.OO 

Total  Accumulation 


$563-7! 


INTEREST   CALCULATIONS  361 

The  first  payment  of  $100.00  made  at  the  end  of  the  first  year 
will  accumulate  for  four  years  at  6  per  cent  convertible  annually. 
This,  by  formula  (2),  would  be,  S  =  100(1  +  f)4  =  $126.25. 
The  second  payment  likewise  would  accumulate  for  three 
years,  S  =  100(1  +  i)3  =  $119.10;  the  third  payment  for  two 
years,  S—  100(1  +  z)2  =  $112.36;  the  fourth  for  one  year, 
•S1  =  100(1  +  i)  =  $106.00;  and  the  fifth  does  not  accumulate 
as  it  is  paid  at  the  end  of  the  period.  The  whole  annuity  will 
accumulate  to  the  sum  of  these  quantities  or  $563.71. 

A  general  formula  for  the  accumulation  of  an  annuity  may 
readily  be  developed  from  the  preceding  discussion.  If  Sn  rep- 
resents the  sum  to  which  the  annuity  will  accumulate  in  n  years 
at  rate  i,  convertible  annually,  and  R  the  annuity  payment,  then 
Sn  =  R(i  +  i)n~l  +  R(i  +  *')"~2  +  R(i  +  i)n~3  -  R(i  +  i)  +  R 
=  R{(i  +  i)"'1  +  (i  +  *)n~*  +  (i  +  *)"~8  +  -  +  d  +  *)  +  i}- 
The  expression  inside  the  brackets  on  the  right  side  of  this  equa- 
tion is  a  geometrical  series  which  may  be  summed  to  the  expres- 
sion, 

(i  +  JY  -  i 
f 

Therefore  : 


The  use  of  this  equation  will  be  evident  if  instead  of  using  the 
table  of  accumulations  in  the  illustration  immediately  preceding, 
use  be  made  of  formula  (14). 


5n  .  Iop/(.  +  .06)'  -  .A 

\  .06  / 


.06 

=     563-7I 

In  case  the  annuity  payment  is  one  dollar,  R  in  formula  (14) 
is  i,  and  for  convenience  the  equation  may  be  written  in  this  form, 

frc^i  -  _  d  +  *)n  -  i 

U5)  *n  = ; 

^ 

This  equation  expresses  the  accumulation  of  one  dollar  per  year 
for  n  years  at  the  rate  i  convertible  annually.  An  interesting 
observation  may  be  made  in  regard  to  the  term  on  the  right-hand 


362  PRINCIPLES  OF  ACCOUNTING 

side.  The  numerator  is  the  total  interest  on  one  dollar  for  n 
years  and  the  denominator  is  the  rate  of  interest.  The  equation 
may  be  solved  by  finding  the  amount  to  which  one  dollar  will 
accumulate  to  the  end  of  the  period,  subtracting  i,  and  divid- 
ing by  the  rate  of  interest. 

Since  there  are  but  two  variables  in  this  expression,  moreover, 
the  values  of  Sn  for  different  rates  of  interest  and  periods  of  time 
may  conveniently  be  arranged  in  tabular  form.  This  is  what  is 
done  in  Table  III  of  Appendix  B.  This  table  is  of  service  in 
finding  the  accumulation  of  annuities  similar  to  the  one  already 
used  in  the  illustration  above.  In  Table  III  in  the  column  headed 
6  per  cent  the  amount  for  five  periods  is  5.6370930.  This 
amount  substituted  in  equation  (14)  gives, 

Sn  =  100(5.6370930) 
=  563-71 

Another  kind  of  case  arises  when  the  annuity  payments  are 
made  in  installments  more  frequently  than  once  a  year  and  in- 
terest is  convertible  the  same  number  of  times  per  year.  For 
example,  if  the  annuity  just  mentioned  in  the  preceding  illus- 
tration were  payable  in  semiannual  installments  and  the  rate 
were  6  per  cent  convertible  semiannually,  what  would  be  the 
sum  accumulated  ?  It  may  readily  be  seen  that  the  result  would 
be  the  same  as  though  an  annuity  of  $50.00  per  year  were  ac- 
cumulated for  ten  years  at  3  per  cent  convertible  annually. 
This  fact  may  be  expressed  in  the  following  formula, 


\3  1  in) 
.Q3)10 


2  .03 

The  value  of  the  term  in  the  brackets  may  be  found  in  the  column 
headed  3  per  cent,  opposite  the  tenth  period  in  Table  III.  This 
amount,  11.4638793,  substituted  in  the  equation  gives, 

Smn  =  50(11.4638793) 
=  573-19 

Formula  (16)  is  merely  a  restatement  of  (14),  the  period  being 


INTEREST   CALCULATIONS 


363 


changed  from  the  year  to  i/mih  part  of  a  year,  and  the  rate  of 
interest  to  the  rate  per  period. 

A  different  case  arises  when  the  payments  are  made  at  the  end 
of  each  year  but  the  interest  is  converted  m  times  per  year.  For 
example,  if  $100.00  is  placed  in  a  fund  at  the  end  of  each  year  for 
five  years,  but  the  interest  is  converted  semiannually,  what 
would  be  the  accumulation?  The  following  table  illustrates 
the  situation. 


END  OF  YEAR 

PAYMENT  TO  FUND 

EXPRESSION  FOR  ACCUMU- 
LATION TO  THE  END  OF 

STH  YEAR 

ACCUMULATION  AT  6% 
CONVERTIBLE  SEMI- 
ANNUALLY 

I 
2 

3 

4 

flOO.OO 
IOO.OO 

IOO.OO 
IOO.OO 

100(1  -\-j/m)8 
100(1  +  j/m)6 
100(1  +y/w)4 
100(1  +_//m)2 

$L26.68 
119.41 
112.54 
106.09 

5 

IOO.OO 

100.00 

Total 

$  =564.  7  2 

An  equation  to  express  the  general  case  of  this  type  may  be  de- 
veloped by  substituting  for  I  in  equation  (14)  its  equivalent  in 
terms  ofy  and  m  from  equation  (5).  This  gives, 


(i?) 


e<m> 

On          = 


(i  +  j/m)m  —  i 


A  table  could  be  prepared  for  the  expression  in  the  brackets  but 
as  this  problem  does  not  frequently  arise  in  accounting  practice 
one  has  not  been  included  in  this  text.  Table  I  can  be  used, 
however,  to  aid  in  its  solution.  The  term  (i  -f-  j/m)™1  in  the 
numerator  and  the  term  (i  -f-  j/m)m  in  the  denominator  can  both 
be  obtained  from  this  table.  In  the  illustration  just  given,  for 
example,  the  numerator  would  be, 

(i  +  .03)10  -  i  =  1.3439164  -  i 
and  the  denominator, 

(i  +  -03)2  —  i  =  1.0609  ~"  z 
Dividing  the  numerator  by  the  denominator,  the  result  is  : 

.3439164  ^  .0609  =  5.64722 


364 


PRINCIPLES  OF  ACCOUNTING 


Substituting  this  quantity  in  equation  (17)  the  result  is, 

SnM   =    100(5.64722) 

=  564-72 

There  is  still  one  further  possibility  which  should  be  discussed 
in  this  section.  The  annuity  payments  might  be  made  at  cer- 
tain intervals  throughout  the  year  and  the  interest  compounded 
at  different  periods.  Suppose  for  example  that  an  annuity  of 
$100.00  per  year  is  payable  in  four  equal  installments  but  that 
interest  is  converted  but  twice  a  year  at  the  nominal  rate  of  6  per 
cent.  This  case  may  be  placed  in  tabular  form  as  follows : 


PERIOD 

PAYMENT 

EXPRESSION  FOR  ACCUMULA- 
TION TO  END  OF  STH  YEAR 

ACCU  MULATION 
AMOUNT  AT  END 
OF  STH  YEAR 

I 

$25 

25(i+.o3)»i 

$33-  I0 

2 

25 

25(1  +-03)9 

32.62 

3 

25 

25(i-f--O3)8* 

32.14 

4 

25 

25(1  +-03)8, 

31.67 

5 

25 

25(1  +.o3)7* 

31.20 

6 

25 

25(1  +  .03)7 

30.74 

7 

25 

25(i+.o3)62 

30.29 

8 

25 

25(1  +  .03)6 

29.85 

9 

25 

25(1  +.03)  5* 

29.41 

10 

25 

25(1  +-03)6 

28.98 

ii 

25 

25(i-f-.03)42 

28.56 

12 

25 

25(1  +.03)4 

28.14 

13 

25 

25(1  +  .  O3)3* 

27.72 

14 

25 

25(1  +  -°3)3 

27.32 

15 

25 

25(1  +  .  03)2* 

26.92 

16 

25 

25(i  +  .Q3)2 

26.52 

17 

25 

25(1  +  .03)^ 

26.13 

18 

25 

25(1  +.Q3)1 

25-75 

19 

25 

25(l  +  .03)» 

25-37 

20 

25 

25.00 

Total 

$^77  4.3 

^^  O  1    1    *T"vJ 

The  first  payment  is  made  at  the  end  of  three  months  and  ac- 
cumulates for  four  and  three-fourths  years.  As  this  principal 
will  accumulate  in  accordance  with  formula  (4)  where  n  is  4f 
and  m  is  2,  the  exponent  is  therefore  9^.  As  the  second  payment 


INTEREST  CALCULATIONS  365 

at  the  end  of  six  months  accumulates  for  four  and  one-half  years, 
the  exponent  is  9.  The  accumulation  of  the  whole  annuity  is 
the  total  of  the  sums  of  each  one  of  the  payments  as  shown  by 
these  expressions.  The  only  new  complication  here  is  the  use 
of  fractional  exponents,  and  the  computation  can  be  abbreviated 
through  the  use  of  logarithms. 

A  general  equation  covering  this  case  can  be  developed  through 
the  summation  formula  for  geometrical  series.  If  the  symbol 
p  represents  the  number  of  payments  made  per  year,  and  all 
other  symbols  are  used  as  before,  then 


Sn(p)  =  Rid  +j/m)m(n~l/»  +  (i 

+  (i  +j/m)'«9-*/ti  H  -----  h  (i  +j/m)ml*  +  ij 

The  right-hand  member  of  this  equation  is  a  geometrical  series. 
Substituting  the  summation  of  this  series  in  the  above  equation 
gives, 


P  (i  +j/m)m/P  -  i 

To  illustrate  the  use  of  this  formula  take  the  illustration  in  the 
preceding  paragraph.  Here  R  is  $100.00  ;  /,  4  ;  j,  6  per  cent  ; 
and  m,  2.  Therefore, 

I0°  (i  +  .Q3)10  —  i 


e  M  _ 


4     (i  +  .03)*  -  i 
=  577-43 


The  only  term  in  this  equation  which  is  somewhat  difficult  to 
obtain  is  (i  +  .03)^.  This  cannot  usually  be  found  in  ordinary 
interest  tables  such  as  are  given  in  the  back  of  this  book  but  with 
the  use  of  logarithmic  tables  the  solution  is  greatly  simplified. 

PRESENT   WORTH   OF   AN   ANNUITY 

What  is  the  discounted  present  value  of  an  annuity?  This 
question  is  evidently  the  converse  of  that  discussed  in  the  pre- 
ceding section.  The  answer  to  this  question  can  also  be  de- 
veloped in  a  similar  manner  for  it  is  evident  that  the  discounted 
value  of  all  annuity  payments  must  be  the  sum  of  the  discounted 
values  of  each  payment.  Further,  the  present  value  of  each 


366  PRINCIPLES  OF  ACCOUNTING 

payment  may  be  found  from  the  formulae  in  the  second  section 
in  the  chapter. 

To  make  the  problem  concrete,  what  should  be  the  purchase 
price  of  an  annuity  of  $100.00  per  year  payable  at  the  end  of  each 
year  for  five  years,  if  the  investor  desires  to  realize  6  per  cent  con- 
vertible annually  on  his  investment  ?  He  is  investing  in  five  sums 
due  at  different  times,  and  the  following  table  shows  the  present 
value  of  the  series  as  determined  from  formula  (n). 

The  first  $100.00  payment      P  =  100  -  =  $94.34 

i  +  .06 

The  second  $100.00  payment  P  =  100 =     89.00 

(i  +  .o6)2 

The  third  $100.00  payment    P  =  100 =    83.96 

(i  +  .o6)3 

The  fourth  $100.00  payment  P  =  100 =     79.21 

(i  +  .06)* 

The  fifth  $100.00  payment      P  =  100 -  =     74.73 

(i  +  -o6)5      

The  present  value  of  the  annuity  $421.24 

That  is,  if  the  investor  turned  over  $421.24  and  received  in  return 
an  annuity  of  $100.00  per  year  for  five  years,  he  would  realize 
6  per  cent  interest  on  his  investment. 

A  general  formula  for  expressing  the  present  value  of  an  annuity 
can  easily  be  developed.  If  An  represents  the  present  value  of 
an  annuity  of  R  per  year  for  n  years,  at  the  rate  i,  then 

An  =   R\— 1—+— ^—  +— 4-T-.    +   -  + 


*)  (l+*)8  (!+*)»  (1+*)" 

The  term  in  the  brackets  is  a  geometrical  series  which  can  be 
summed  to  the  expression  : 


INTEREST   CALCULATIONS 


367 


Placing  this  expression  in  the  above  equation,  it  becomes, 

i 


d9) 


'«  =  R 


d-H)n 


Thus,  the  present  value  of  the  annuity  in  the  illustration  given 
above  would  be, 

i 


An  =    IOO 


I   — 


-o6) 


.06 


=  421.24 


In  case  the  annuity  payment  is  one  dollar,  equation  (19)  may 
be  written, 

i 


(20) 


i  — 


(i  +  *)« 


This  is  the  expression  for  the  present  value  of  one  dollar  per  year 
for  «  years  at  rate  i.  The  numerator  of  the  fraction  is  one  minus 
the  present  value  of  one  dollar  due  n  years  from  date,  while  the 
denominator  is  the  rate  of  interest.  Computations  from  this 
formula  would  be  quite  simple  in  most  cases,  but  Table  IV  in 
Appendix  B  gives  the  values  of  An  for  several  different  rates  of 
interest.  For  example",  the  present  value  of  one  dollar  per  year 
for  five  years  at  6  per  cent  (4.2123638)  may  be  found  in  the 
column  headed  6  per  cent  and  opposite  the  fifth  period.  This 
quantity  substituted  in  formula  (19)  for  the  preceding  illustra- 
tion gives, 

An   =    100(4.2123638) 
=    421.24 

Now  as  a  second  case  suppose  that  the  annuity  payments  of 
$100.00  are  in  semiannual  installments  and  that  the  interest 
rate  is  6  per  cent  convertible  semiannually.  The  present  value 
of  this  annuity  is  the  same  as  an  annuity  of  $50.00  per  year  for 
ten  years  at  3  per  cent  convertible  annually.  Expressed  in 
general  terms  this  question  would  be,  what  is  the  present  value 
of  an  annuity  of  R  per  year  payable  m  times  per  year  for  n  years 


368 


PRINCIPLES  OF  ACCOUNTING 


at  the  nominal  rate  of  j  convertible  m  times  per  year  ?     TW  equa- 
tion for  this  is, 


(21) 


A     = 

•"•win  — 

m 


I  — 


+  j/m)mn 


j/m 


In  the  problem  as  stated  the  amounts  would  be, 


. 


TOO 
2 


I  — 


(i  +  -03) 


10 


•03 

=  50(8.5302028) 
=  426.51 

The  value  of  the  term  in  the  brackets  is  found  in  Table  IV  in 
the  3  per  cent  column  opposite  the  tenth  period.  Valuations  of 
annuities  of  this  class  can  be  made  in  this  manner  with  the  aid 
of  Table  IV. 

A  somewhat  different  situation  arises  when  the  annuity  pay- 
ments are  made  annually  but  the  interest  is  convertible  m  times 
per  year.  The  formula  for  this  case  can  be  obtained  by  sub- 
stituting for  i  in  equation  (19)  its  equivalent  in  terms  of  j  and  m, 
which  gives, 

i 


02) 


tn(m)  =  R 


i  — 


-\-  j/m)mn 


(i  -f-  j/m)m  —  i 


If  the  annuity  payments  of  $100.00  for  five  years  are  made  at 
the  end  of  each  year,  for  example,  and  the  interest  rate  is  6  per 
cent  convertible  semiannually,  formula  (22)  can  be  used  as 
follows, 


A™  =  100 


i  — 


(i  +  -03) 


10 


+  -03) 


2  _ 


The  second  term  in  the  numerator  of  the  fraction  in  this  formula 
can  be  found  in  Table  II,  in  the  3  per  cent  column.     The  amount 


for  the  tenth  period  ( j  is  . 

Wi+.o<W 


7440939.     The  first  term 


INTEREST  CALCULATIONS  369 

in  the  denominator,  (i  -f-  .O3)2,  can  be  found  in  Table  I,  in  the  3 
per  cent  column  and  for  the  second  period,  1.0609.  Substitut- 
ing these  quantities  in  the  above  equation  the  result  is, 

An™=  ioo'fl"  -74409391 
I    1.0609  ~  I    I 
=  420.21 

This  illustrates  the  common  cases  of  this  type.     Tables  have  not 

i 

been  prepared  for  the  values  of  the  expression — — - — 

(i  +  j/m)m  —  i 

therefore  the  fraction  must  be  solved  in  the  detail  form  as  shown. 
A  third  type  of  cases  arises  when  the  annuity  payments  are 
made  p  times  per  year  but  interest  is  converted  m  times  per  year. 
For  example,  what  would  be  the  purchase  price  of  an  annuity 
of  $100.00  per  year,  payable  in  four  installments  of  $25.00  for 
five  years  at  6  per  cent  convertible  semiannually  ?  This  case 
can  be  presented  in  tabular  form  as  shown  on  page  370. 

Formula   (13),   P  =  S ,  is  used  to  obtain  thepres- 

(i  +  j/m}mn 

ent  value  of  each  payment.  Thus  for  the  first  payment,  m  is 
2  and  n,  f ,  and  the  exponent  of  (i  -\-j/vn)mn  is  therefore  |.  For 
the  second  payment,  m  is  2  and  n,  ^,  which  makes  the  exponent  i, 
etc.  Moreover  as  the  present  value  of  the  annuity  is  the  pres- 
ent value  of  all  of  the  payments,  the  general  formula  would 
evidently  be, 

i.i,  i 


(\+Jlm}mlv      (i+j/m)m2/p     (i+y/w)m3/p 


)m(1  -1/p)      (i  +  j/m}mn 

The  term  in  the  brackets  is  a  geometrical  series  which  can  be 
summed  to  the  expression, 


_  j/m)mn 

P  (i 

2B 


37° 


PRINCIPLES  OF  ACCOUNTING 


PERIOD 

PAYMENT 

EXPRESSION  FOR 
PRESENT  VALUE 

PRESENT  VALUE 

toe 

*  •,  .   A  , 

*25 

~J(i  +  .o3)i 

I 

*24-O3 

23 

25(i  +  .o3)i 

24.27 

. 
•, 

25 

'   (1  +  .Q3H 

23.Q2 
-,    ,-< 

4 

25 

'J(i  +  .o3)2 

23-S» 

2a 

"J(i  +  .o3)2i 
a-       i 

23.22 

--    QQ 

25 

""(I  +  -03)3 

I 

7 

2S 

"Jd  +  -o3)3i 

I 

22.54 

25 

"J(I  +  .03)* 
I 

»»   Q~ 

9 

2S 

"J(i+.o3)4i 
i 

2I.OQ 
i    ^< 

10 

25 

J(i  +  -o3)5 
i 

21.50 

ii 

25 

"J(i  +  .o3)H 
i 

12 

25 

"J(i+.o3)6 

I 

20.Q4 
.«  <-, 

13 

2S 

""(I  +  -03)6i 

I 

20.03 

14 

25 

"(i  +  .o3)7 

I 

20.33 

rs 

tf\ 

25 

"(i  +  .o3)4 

I 

2O.O3 

25 

J(i  +  .o3)8 

I 

19.74 

J7 
To 

25 

"(i  +  -o3)8i 
i 

1944 

25 

"(i  +  .o3)9 
i 

19.10 

J9 

25 

"(i  +  .o3H 
I 

lo.oo 

25 

"(l+.03)'° 

IO.OO 

Total  

$429.68 

INTEREST  CALCULATIONS  371 

Placing  this  expression  in  the  equation  the  result  is, 


JtllT 


(23)  AmnM  =  -\         (i+y/m)- 

P 


—  i 


The  only  part  of  this  equation  which  is  difficult  to  solve  is  the 
term  (i  +  j/m)m/p  when  p  is  greater  than  m.  In  such  cases  it 
is  usually  necessary  to  use  logarithms  to  extract  the  root  indicated 
by  the  fractional  exponent.  The  expression  in  the  numerator 
can  be  obtained  from  Table  II.  To  illustrate  the  use  of  this 
formula,  take  the  case  just  given.  Here, 


TOO      T    — 


=^-r    (i +  .03)*° 

4     I  -7 : Ti 

(i  +  .03)f  -   I 

=  429.68 

There  is  still  one  further  case  in  the  valuation  of  annuities  of 
sufficient  importance  to  be  mentioned  in  this  section,  namely  a 
perpetuity.  If  an  annuity  of  R  per  year  is  payable  perpetually, 
the  value  can  be  obtained  from  formula  (19).  In  this  case,  n 
is  infinity  and  the  equation  becomes, 

i 

I     —  .00 

An  =  R ILZJL 

^ 

The  fraction  - — ; — 173  is  zero  in  any  case,  however,  and  the  equa- 

(i  T  *) 
tion  can  therefore  be  written, 

(24)  A*>=~j 

IOO 

Thus  a  perpetuity  of  $100.00  per  year  is  worth  at  6  per  cent,  — 

or  $1,666.67.  This  method  of  valuing  perpetuities  is  used  very 
frequently,  particularly  in  placing  values  on  capital  stock.  A 
share  of  stock  with  a  par  value  of  $100.00  on  which  a  dividend 

10 
of  10  per  cent  is  consistently  paid,  for  example,  will  sell  at  -^ 

or  $166.67,  if  valued  at  the  rate  of  6  per  cent. 


372  PRINCIPLES  OF  ACCOUNTING 


SINKING  FUND   CONTRIBUTIONS 

The  contract  covering  a  bond  issue  frequently  imposes  upon 
the  issuing  corporation  the  responsibility  of  accumulating  a 
fund  for  the  purpose  of  retiring  the  bonds  at  maturity.  Con- 
tributions are  made  to  the  fund  in  the  form  of  annuity  payments 
and  usually  these  bear  interest  which  is  also  added  to  the  fund. 
In  such  cases  it  is  desirable  to  make  the  annuity  payment  just 
large  enough  to  permit  the  fund  to  accumulate  with  the  interest 
additions  to  the  desired  sum  and  no  more.  That  is,  if  the  fund 
must  accumulate  to  $1,000.00  at  the  end  of  five  years,  the  annuity 
payment  will  evidently  be  less  than  $200.00,  the  actual  amount  de- 
pending on  the  rate  of  interest  which  can  be  earned  by  the  fund. 
Stated  in  general  terms,  the  problem  is  to  determine  the  annuity 
payment  which  will  accumulate  to  a  definite  sum  in  the  future  at 
a  given  rate  of  interest.  Equation  (14)  expresses  the  sum  to 
which  an  annuity  of  R  per  year  will  accumulate  in  n  years  at 
rate  i.  The  present  problem  is  merely  the  converse  of  this  and 
may  be  solved  by  finding  the  value  of  R  in  that  equation.  Thus 
since, 


then, 


If  the  fund  is  to  accumulate  to  $1,000.00  in  five  years  at  4  per  cent 
convertible  annually  then, 

.04 

R  =  1,000 -T 

(I.04)5  -  i 

=  i,ooo(. 1846271) 

=  184.63 

The  sinking  fund  payments  of  $184.63  will  accumulate  in  five 
years  to  $1,000.00,  as  shown  by  the  following  table : 


INTEREST  CALCULATIONS 


373 


(I) 

(2) 

(3) 

(4) 

(5) 

YEAR 

FUND  AT  BEGINNING 

INTEREST  ON  FUND 

ANNUITY  PAYMENT 

FUND  AT  END  op 

of  YEAR 

DURING  YEAR 

AT  END  OF  YEAR 

YEAR 

I 

$      0.00 

$   0.00 

$184.63 

$184.63 

2 

184.63 

7.38 

184.63 

376.64 

3 

376.64 

15.06 

184.63 

576.33 

4 

576.33 

23.05 

184.63 

784.01 

5 

784.01 

31.36 

184.63 

I,OOO.OO 

When  the  amount  to  be  accumulated  is  i,  equation  (25)  may 
be  written, 


(26) 


r  = 


.     ,     . 

(i  +  *)"  -  i 

This  is  the  reciprocal  of  equation  (15)  and  might  be  written, 


The  value  of  r  in  this  equation  can  be  obtained  by  taking  the 
reciprocal  of  the  quantity  found  in  Table  III  at  the  given  rate  of 
interest  and  for  the  same  number  of  years.  A  special  table  has 
been  included  in  Appendix  B  for  the  value  of  r  in  equation  (26). 
To  find  the  annuity  payments  which  will  accumulate  to  one  dol- 
lar in  five  years  at  4  per  cent,  for  example,  refer  in  Table  V  to 
the  4  per  cent  column  opposite  the  fifth  period.  The  amount 
given  here  is  .1846271,  and  if  the  amount  to  be  accumulated  is 
$1,000.00  multiply  by  1,000,  and  the  result  is  $184.63.  This  is 
the  amount  shown  in  the  computation  above. 

If  the  sinking  fund  payment  of  R  per  year  is  paid  into  the  fund 
m  times  per  year,  and  interest  is  convertible  m  times  per  year, 
the  amount  of  each  contribution  may  be  obtained  by  solving 

n 

equation  (16)  for  — ,  thus, 


R 

m 


j/m 


(27)  m      "mn\(i+j/m)m»-  i 

For  example,  to  find  the  semiannual  payment  to  a  sinking  fund 


374  PRINCIPLES  OF  ACCOUNTING 

which  will  accumulate  to  $1,000.00  in  five  years  at  4  per  cent 
convertible  semiannually,  this  formula  may  be  used. 

R  \  .02 

—  =  i  ,000 


m  I(i  +  .o2)10-i 

The  term  in  the  brackets  may  be  found  in  the  2  per  cent  column, 
opposite  the  tenth  period,  in  Table  V. 

• 

D 

-  =  1,000  (.0913265) 
m 

=  Qi-33 

That  is,  $91.33  placed  in  a  fund  every  six  months,  and  accumulat- 
ing at  4  per  cent  convertible  semiannually,  will  amount  to 
$1,000.00  at  the  end  of  five  years. 


THE   ANNUITY   WHICH   A   PRINCIPAL   WILL   PURCHASE 

This  question  frequently  arises,  particularly  in  the  admin- 
istration of  estates.  What  sum  will  a  certain  principal  purchase 
at  a  given  rate  of  interest?  In  this  case  a  certain  sum  is  avail- 
able for  investment  and  it  is  desired  to  determine  the  annuity  in 
which  it  may  be  invested.  If  the  annuity  to  be  purchased  is  a 
perpetuity,  the  question  is  easily  answered.  The  annual  pay- 
ments will  be  the  principal  multiplied  by  the  rate  of  interest  in- 
volved. Thus  the  perpetuity  which  $100,000.00  will  purchase 
at  4  per  cent  is  evidently  $4,000.00.  But  if  the  annuity  is  to  run 
for  a  limited  period,  a  more  complex  situation  arises.  If  the 
$100,000.00  is  to  be  invested  in  a  twenty-year  annuity  at  4  per 
cent,  instead  of  a  perpetuity,  for  example,  what  will  be  the 
annual  payment?  Stated  in  another  way,  $100,000.00  is  the 
present  value  of  a  twenty-year  annuity  of  R  dollars  per  year  at 
4  per  cent,  and  it  is  desired  to  determine  the  amount  of  R.  Now 
formula  (19)  expresses  the  present  value  of  an  annuity  of  R  per 
year  as, 

f/T  * 

(l  ~~    / 


INTEREST  CALCULATIONS 


375 


In  the  present  problem  An  is  known  but  R  is  not,  therefore  solv- 
ing for  R  the  equation  is, 

i 

(28)  R  =  An    ~          ~ 

(i  +  *)". 

In  the  problem  under  consideration,  An  is  $100,000.00  and  the 
value  of  R  may  be  found  from  formula  (28). 


R  =  100,000 


.04 


i  — 


.o4)20J 


=  100,000  (.0735817) 

=  7.358.17 


That  is,  $100,000.00  will  purchase  an  annuity  of  $7,358.17  per 
year  for  twenty  years  at  4  per  cent. 


It  may  be  noticed  that  the  expression 


i  — 


is  the  re- 


ciprocal  of  the  right-hand  member  of  formula  (26).  The  value 
of  this  expression  may  easily  be  obtained  by  taking  the  reciprocals 
of  the  amounts  shown  in  Table  IV  for  the  same  rates  of  interest 
and  number  of  periods.  The  amount  .0735817,  for  example, 
may  be  found  by  dividing  i  by  the  quantity  found  in  Table 
IV  in  the  4  per  cent  column,  opposite  the  twentieth  period. 

If  it  is  desired  to  find  the  annuity  payable  m  times  per  year 
for  n  years,  which  a  given  principal  will  purchase  at  the  rate  j, 
convertible  m  times  per  year,  this  may  be  done  by  solving  the 

following  expression  for  — . 


m 


(29) 


m 


j/m 


i  — 


+  j/m)mn 


If  the  $100,000.00  fund  of  the  preceding  illustration  were  to  be 
invested  in  a  twenty-year  annuity,  the  payments  of  which  were 


376  PRINCIPLES  OF  ACCOUNTING 

made  semiannually,  and  interest  is  involved  at  the  rate  of  4  per 
cent  convertible  semiannually,  then, 


.02 
R 

—  =    100,000 
2  I   — 


(I.02)40J 

=  100,000  (.0365557) 

=  3,655-57 

This  is  the  semiannual  annuity  payment. 


THE   APPORTIONMENT   OF   ANNUITY  PAYMENTS 

When  a  principal  sum  has  been  invested  in  an  annuity,  the  in- 
vestor receives  in  return  both  his  investment  and  interest  in  the 
annuity  payments.  In  order  to  keep  the  investment  intact,  it 
is  necessary  to  apportion  the  annuity  payments  between  the 
return  of  the  investment  and  the  interest  earning.  To  take  a 
concrete  case,  suppose  that  corporation  A  offers  a  five-year 
annuity  of  $20,000.00  per  year,  payable  in  semiannual  install- 
ments, and  that  Mr.  B  purchases  the  annuity  on  a  5  per  cent  basis 
interest  convertible  semiannually.  The  purchase  price  (found 
by  formula  (21))  is  $87,520.64.  Mr.  B  then  invests  an  estate 
of  $87,520.64  in  a  security  which  will  pay  him  $100,000.00  during 
the  succeeding  five  years.  Now  it  is  evident  that  the  interest 
earned  on  the  whole  transaction  is  $100,000.00  minus  $87,520.64 
or  $12,479.36.  But  at  what  time  is  this  interest  earned  ?  Surely 
a  certain  part  of  each  annuity  payment  contains  some  interest. 
The  question  is,  how  much  of  each  payment  is  interest,  and  how 
much  a  return  of  the  original  investment  of  $87,520.64?  This 
apportionment  is  shown  in  the  table  on  page  377. 

At  the  end  of  the  first  six  months  $10,000.00  is  received. 
Since  an  investment  of  $87,520.64  was  made  at  the  beginning  of 
this  period,  on  a  5  per  cent  basis  interest  convertible  semi- 
annually, Mr.  B  has  earned  i\  per  cent  on  this  amount  at  the 
time  of  the  first  payment.  The  amount  of  interest  on  this  basis 
is  82,188.02,  and  $7,811.98,  the  balance  of  the  annuity  payment, 
is  evidently  a  return  of  part  of  his  original  investment.  The 


INTEREST   CALCULATIONS 


377 


amount  remaining  invested  at  the  beginning  of  the  second  period 
is  $79,708.66,  on  which  i\  per  cent,  or  $1,992.72  is  earned  during 
this  period.  The  balance  of  the  payment,  $8,007.28,  constitutes 
a  further  return  of  investment.  The  succeeding  annuity  pay- 
ments are  apportioned  in  like  ma  *  ,  and  when  the  last  payment 
is  received,  the  total  investment  will  have  been  returned  together 
with  interest  on  it  to  the  amount  of  $12,479.36.  Further,  the 
interest  has  been  accounted  for  in  the  years  during  which  it  was 
earned.  The  maintenance  of  the  integrity  of  the  accounting 
period  hals  been  sufficiently  emphasized  in  preceding  chapters 
to  show  the  necessity  for  such  apportionment  in  any  case. 


(l) 

(2) 

(3) 

(4) 

(5) 

HALF-YEAR 
PERIOD 

INVESTMENT 
BEGINNING  OF 
PERIOD 

ANNUITY 
PAYMENT 

INTEREST 

RETURN  OF 
INVESTMENT 

I 

$87,520.64 

$IO,OOO.OO 

$2,188.02 

$7,811.98 

2 

79,708.66 

IO,OOO.OO 

1,992.72 

8,007.28 

3 

71,701.38 

IO,OOO.OO 

1,792.53 

8,207.47 

4 

63,493.91 

IO,OOO.OO 

1,587.35 

8,412.65 

5 

55,081.26 

IO,OOO.OO 

1,377-03 

8,622.97 

6 

46,458.29 

IO,OOO.OO 

1,161.46 

8,838.54 

7 

37,619.75 

IO,OOO.OO 

940.49 

9,059.5I 

8 

28,560.24 

IO,OOO.OO 

714.01 

9,285.99 

9 

19,274.25 

IO,OOO.OO 

481.85 

9,5l8.I5 

10 

9,756.10 

IO,OOO.OO 

243.90 

9,756.10 

Total 

$IOO,OOO.OO 

$12  4.70  36 

$87  520  64 

In  general,  then,  annuity  payments  may  be  apportioned  be- 
tween investment  and  interest,  (i)  by  multiplying  the  rate  per 
period  by  the  investment  at  the  beginning  of  the  period  to  find 
the  amount  of  interest,  and  (2)  by  deducting  the  amount  of 
interest  thus  found  from  the  annuity  payment  to  find  the  return 
of  principal.  In  the  illustration  given,  the  dates  for  annuity 
payments  and  for  converting  interest  correspond.  In  case  the 
frequency  of  conversion  differs  from  the  number  of  annuity 
payments  the  interest  earned  each  period  can  be  determined 
from  the  proper  formula  in  the  preceding  section,  and  the  second 
step  would  be  the  same  as  stated  above. 


378  PRINCIPLES  OF  ACCOUNTING 

THE   VALUATION  OF   BONDS 

The  most  common  type  of  contractual  security  in  American 
finance  is  the  bond.  A  bond  is  a  security  which  contains  (from 
the  point  of  view  of  accounting  at  least)  two  promises  to  pay, 
OTZ.,  (i)  a  definite  sum  at  a  future  date,  called  the  par,  and  (2) 
an  annuity  from  date  of  issue  until  the  par  is  paid,  called  bond 
interest.  The  amount  of  the  annuity  payment  is  usually  ex- 
pressed as  a  percentage  of  the  par.  Thus  a  five-year,  $1,000.00, 
4  per  cent  bond,  interest  payable  semiannually,  consists  of  (i)  a 
promise  to  pay  $1,000.00  at  the  end  of  five  years,  and  (2)  an 
annuity  of  $40.00  per  year  payable  semiannually  for  five  years. 
The  4  per  cent  stated  in  the  bond  serves  no  other  accounting 
purpose  than  to  express  the  amount  of  the  annuity  payment. 

What,  then,  is  the  investment  value  of  a  bond  ?  It  is  evident 
that  this  figure  will  be  the  sum  of  the  present  values  of  the  two 
promises  to  pay.  This  sum  can  be  conveniently  expressed  in  a 
formula.  If  B  represents  the  present  value  of  a  bond ,  5,  the 
par  value ,  and  R  the  annual  payment  of  bond  interest,  payable 
m  times  per  year ;  and  if  the  nominal  rate  of  interest  is  j,  con- 
vertible m  times  per  year,  the  formula  for  determining  the  pres- 
ent value  is,1 

i 

(3°)       B  =  s          I  _i_R        (i+j/m)mn 

(i  +  j/m)mn     m  j/m 

Thus  if  the  4  per  cent,  $1,000.00  bond  mentioned  in  the  preceding 
paragraph  were  valued  on  a  5  per  cent  basis,  the  equation  just 
given  would  show, 

B.^oool,-^^}^!1   c+-s)-l 


2    [  .025 


1  See  formula  (13)  for  the  present  value  of  a  sum,  and  formula  (21)  for  the 
present  value  of  an  annuity.  There  are  bond  tables  prepared  which  give  the 
values  of  B  in  this  equation  for  different  bond  and  market  rates  of  interest. 

The  formula  may  readily  be  solved  in  most  cases  by  using  Table  II  for  the 


expression 


[z L__] 

-, }  and  Table  IV  for  J (*  +j/m)mn 

i  +j/m)nnl  j/m 


INTEREST   CALCULATIONS 


379 


If  the  investor  wished  to  realize  5  per  cent  convertible  semi- 
annually  on  his  investment,  the  purchase  price  of  the  bond  would 
be  $956.24.  This  figure  is  called  the  purchase  price  or  present 
value  of  the  bond.  The  excess  of  par  value  over  the  present 
value  is  called  the  bond  discount.  The  accumulation  of  bond 
discount  between  the  date  of  issue  and  the  date  of  maturity  will 
be  discussed  in  the  next  section. 

It  will  be  of  interest  to  find  the  value  of  this  4  per  cent  bond  on 
two  other  interest  rate  bases,  4  per  cent  and  3  per  cent  for  example. 
If  the  market  rate  of  interest  is  4  per  cent,  then 


=  I,OOO- 

.02 

'  *  V 

=    1,000.00 


In  this  case  the  present  value  of  the  bond  is  equal  to  the  par  and 
the  bond  is  said  to  be  sold  at  par.  The  bond  interest  just  equals 
the  market  interest  at  each  payment  date.  If,  now,  the  market 
rate  were  3  per  cent,  the  present  value  would  be, 


i  — 


(i  +  .ois)10 

B  =  1,000  <  }  +   20  > 

\    i         i  \in  I      ' 


.oi5)10j  I  ,015  j 

=  1046.11 

The  present  value  here  exceeds  the  par  and  the  amount  of  the 
excess  is  called  premium.  The  bond  is  said  to  be  sold  at  a  pre- 
mium. The  treatment  of  the  premium  between  date  of  issue  and 
maturity  will  be  discussed  in  the  next  section. 

Bond  interest  on  the  ordinary  bond  is  payable  twice  a  year, 
and  interest  on  bond  valuations  is  usually  converted  semi- 
annually.  The  above  formula  for  bond  valuation,  therefore, 
covers  most  cases  which  arise  in  practice.  Other  conditions  are 
possible,  however,  such  as  bond  interest  payable  annually,  while 
interest  is  convertible  semiannually,  or  vice  -versa.  Or  the  bond 
interest  might  be  payable  quarterly  or  oftener  while  the  interest 
is  convertible  less  frequently,  etc.  All  such  cases  may  be  solved 
by  using  a  combination  of  the  proper  equations  for  the  present 
value  of  a  sum  and  for  the  present  value  of  an  annuity  as  given 


PRINCIPLES  OF  ACCOUNTING 


in  the  preceding  sections.     It  is  only  necessary  to  consider  the 
bond  as  made  up  of  the  two  parts  as  suggested. 

In  the  illustrations  given  above,  it  was  shown  that  when  the 
bond  interest  rate  and  the  rate  of  interest  used  in  the  valuation 
are  the  same,  the  present  value  is  equal  to  par ;  when  the  interest 
rate  is  greater  than  the  bond  rate,  the  present  value  is  less  than 
par ;  and  when  the  interest  rate  is  less  then  the  bond  rate,  the 
present  value  is  greater  than  par.  Now  it  may  easily  be  demon- 
strated that  the  difference  between  the  par  and  present  value  is 
equal  to  the  present  value  of  an  annuity,  the  annual  payment  of 
which  is  measured  by  the  difference  between  the  bond  interest 
payment  and  the  amount  the  bond  interest  payment  would  be 
at  the  market  rate  of  interest.  Thus  if  R  represents  the  bond 
interest  payment,  payable  m  times  per  year,  and  /  the  amount 
the  bond  interest  payment  would  be  at  the  market  rate,  and  D, 
the  difference  between  the  par  value  and  present  value  of  the 
bond,  then, 


D  = 


R-  I    i  - 


m 


j/m 


If  R  is  less  than  7,  D  is  the  discount ;  if  R  is  greater  than  7,  D  is 
the  premium.  For  example,  the  discount  on  a  4  per  cent,  five- 
year,  $1,000.00  bond,  interest  payable  semiannually,  is,  at  5  per 
cent, 


D  = 


40-  50 


i  — 


(i  +  .025) 


10 


.025 


The  discount,  $43.76,  deducted  from  the  par  leaves  $956.24,  the 
present  value  of  the  bond.  Now  if  the  same  bond  is  valued  on  a 
3  per  cent  basis  the  premium  is, 


D-'  '  (i  +  .o..)" 


=   46.11 


•03 


The  premium,  $46.11,  added  to  the  par  gives  $1,046.11,  the  pres- 
ent value  of  the  bond. 


INTEREST  CALCULATIONS 


ACCUMULATION  AND   AMORTIZATION 

It  is  a  fact  scarcely  needing  demonstration  that  the  difference 
between  the  amount  received  from  the  sale  of  bonds  by  a  cor- 
poration and  the  total  of  the  bond  interest  payments  and  par  is 
interest.  Yet  a  failure  to  recognize  this  fact  has  often  led  to 
erroneous  entries  on  the  books.  Too  often  the  bond  interest 
payments  alone  are  considered  as  actual  interest,  while  discount 
is  considered  as  a  loss  and  premium  as  a  profit.  The  impropriety 
of  this  reasoning  seems  fairly  evident.  If  $956.24,  for  example, 
is  received  fora  $1,000.00, five-year, 4  per  cent  bond,  then  the  total 
interest  is  $1,000.00  plus  $200.00  minus  $956.24,  or  $243.76. 
The  question  immediately  arises,  however,  as  to  the  accounting 
periods  during  which  the  interest  accrues,  or  what,  in  other  words, 
should  be  considered  as  a  net  revenue  charge  in  each  accounting 
period  during  the  life  of  the  bond.  The  interest  actually  accru- 
ing in  each  period  for  the  case  just  stated,  assuming  that  the  rate 
of  interest  involved  in  the  valuation  is  5  per  cent,  would  be  greater 
than  the  amount  of  bond  interest  paid  during  the  same  period. 
This  fact  is  illustrated  in  the  following  table  for  the  accumulation 
of  discount. 


(l) 

(2) 

(3) 

(4) 

(5) 

HALF-YEAR 
PERIOD 

INVESTMENT  IN 
BOND  BEGINNING 
OF  PERIOD 

INTEREST  ON 
INVESTMENT 

BOND  INTEREST 
PAYMENT 

ACCUMULATION 

I 

$956.24 

$23.91 

$2O.OO 

$3-91 

2 

960.15 

24.00 

2O.OO 

4.00 

3 

964-15 

24.10 

2O.OO 

4-IO 

4 

968.25 

24.21 

2O.OO 

4.21 

5 

972.46 

24.31 

2O.OO 

4-31 

6 

976.77 

24.42 

2O.OO 

4.42 

7 

981.19 

24-53 

2O.OO 

4-53 

8 

985.72 

24.64 

2O.OO 

4.64 

9 

990.36 

24.76 

2O.OO 

4.76 

10 

995-12 

24.88 

2O.OO 

4.88 

Total      . 

$243.76 

$2OO.OO 

$43-76 

In  column  (2)  the  figures  given  represent  the  present  value  or 
investment  in  the  bond  at  the  beginning  of  each  half-year  period. 


382  PRINCIPLES  OF  ACCOUNTING 

At  the  beginning  of  the  first  period  the  value  as  already  stated  is 
$956.24.  The  amount  loaned  to  the  corporation  issuing  the 
bond  is  $956.24  and  as  the  rate  of  interest  involved  is  5  per  cent 
convertible  semiannually,  the  amount  of  interest  earned  by  the 
bondholder  or  the  amount  accruing  against  the  net  revenue  of 
the  corporation  during  the  first  period  is  2§  per  cent  of  the  amount 
invested,  or  $23.91.  On  this  date  the  corporation  pays  this 
interest  in  part ;  $20.00  is  paid  on  account,  so  to  speak,  which 
leaves  $3.91  accrued  but  not  paid.  This  latter  amount  ($3.91)  is 
added  to  the  investment,  as  the  bondholder's  equity  in  the  con- 
cern has  —  from  an  accounting  standpoint  —  increased  from 
$956.24  to  $960.15.  Now  since  the  investment  at  the  beginning 
of  the  second  period  is  $960.15,  the  interest  which  accrues  in 
that  period  amounts  to  $24.00.  But  again  the  corporation  pays 
but  $20.00,  which  leaves  $4.00  to  be  added  to  the  investment. 
At  the  end  of  each  period  a  similar  computation  must  be  made 
in  order  that  the  correct  amount  of  interest  may  be  entered  in 
the  Net  Revenue  account.  The  accounting  entries  to  be  made 
at  each  date  will  be  discussed  in  the  next  chapter.  . 

The  amount  of  the  accumulation  (column  (5))  by  the  end  of 
the  fifth  year  is  $43.76.  This  is  just  the  amount, of  the  original 
discount,  and  on  being  added  to  the  original  investment  brings 
that  figure  up  to  par.  The  total  interest,  $243.76,  is  thus  seen 
to  be  paid  in  two  parts ;  $200.00  in  the  form  of  an  annuity  and 
$43.76  in  the  payment  of  par  at  the  end  of  the  fifth  year ;  but  the 
interest  earnings  are  properly  recorded  in  the  periods  during  which 
they  are  earned. 

If  this  bond  were  valued  on  a  3  per  cent  basis,  the  present 
value  would  be  $1,046.11  and  the  total  interest,  $1,200.00  minus 
$1,046.11  or  $153.89.  The  amount  of  interest  for  each  period 
is  shown  in  the  table  (page  383)  for  the  amortization  of  premium. 

The  amount  received  for  the  bond  at  the  outset  is  $1,046.11 ; 
and  since  the  interest  rate  is  3  per  cent,  convertible  semiannually, 
the  amount  of  interest  accruing  during  the  first  half  year  is  i^ 
per  cent  of  this  amount,  or  $15.69.  A  payment  of  $20.00  is  made 
at  this  time,  however,  which  pays  the  interest  accrual  and  $4.31 
of  the  investment  besides,  leaving  the  investment  at  the  begin- 
ning of  the  second  period  at  $1,041.80.  Then  i|  per  cent  on  this 
amount  gives  $15.63,  the  interest  accrual  for  the  second  half 


INTEREST  CALCULATIONS 


383 


year.  The  $20.00  payment  at  this  time  pays  this  interest  and 
$4.37  of  the  investment.  This  process,  carried  on  to  the  end  of 
the  fifth  year,  reduces  the  investment  to  par  at  the  time  the  bond 
is  paid.  The  table  given  below  shows  the  interest  accruing  in 
each  period  in  column  (3),  the  annuity  payments  (bond  interest) 
in  column  (4),  and  the  amount  of  the  returned  investment 
(amortization  of  premium)  in  column  (5).  The  accounting 
entries  concerning  this  case  will  be  discussed  in  the  next  chapter. 


(I) 

(2) 

(3) 

(4) 

(5)  ' 

HALF-YEAR 
PERIOD 

INVESTMENT  IN 
BOND  BEGINNING 
OF  PERIOD 

INTEREST  ON 
INVESTMENT 

BOND  INTEREST 

AMORTIZATION  OF 
PREMIUM 

I 

$1,046.11 

$15.69 

$20.00 

$4-31 

2 

1,041.80 

IS-63 

2O.OO 

4-37 

3 

1,037-43 

I5-56 

2O.OO 

4-44 

4 

1,032.99 

15-49 

20.00 

4-51 

5 

1,028.48 

15-43 

20.OO 

4-57 

6 

1,023.91 

I5-36 

2O.OO 

4.64 

7 

1,019.27 

I5-29 

2O.OO 

4.71 

8 

1,014.56 

15.22 

2O.OO 

4.78 

9 

1,009.78 

I5-I5 

2O.OO 

4-85 

10 

1,004.93 

I5-07 

2O.OO 

4-93 

Total 

$1^.89 

$2OO.OO 

$46.11 

tr  •*  JO  B**y 

DETERMINING   THE   INTEREST  RATE 

In  all  of  the  formulae  given  so  far  in  this  chapter  it  has  been 
assumed  that  the  interest  rate  is  a  known  factor.  The  interest 
rate  is  used  in  the  right-hand  member  of  the  equations  as  a  factor 
in  the  determination  of  the  value  of  the  unknown  quantity  on 
the  left-hand  side.  It  is  possible  to  have  situations  arise,  how- 
ever, where  the  rate  of  interest  involved  is  the  only  unknown 
quantity.  This  case  frequently  arises  in  connection  with  bond 
issues,  and  might  arise  in  any  of  the  other  types  of  securities 
mentioned  in  this  chapter. 

Given  the  purchase  price  and  bond  rate  of  interest  on  a  par- 
ticular bond,  what  is  the  market  rate  of  interest?  A  corporation, 
for  example,  will  offer  a  certain  bond  for  sale  and  the  purchaser 


384  PRINCIPLES  OF  ACCOUNTING 

makes  his  bid  at  a  certain  price.  The  corporation  must  determine 
the  rate  of  interest  involved  in  the  transaction  in  order  to  make 
the  proper  entries  on  its  books.  In  this  case  all  of  the  quantities  in 
formula  (30)  are  known  with  the  exception  of  j,  and  the  problem 
is  to  determine  the  value  of  this  term.  Theoretically  this  can 
be  done  by  solving  the  equation  for  j  but  when  this  is  attempted 
the  resulting  equation  has  terms  in  the  right-hand  member  that 
run  into  such  high  powers  that  it  is  practically  impossible  to  solve 
in  any  given  case.  For  this  reason  the  ordinary  algebraic  method 
of  solution  is  not  resorted  to.  The  only  practicable  method  avail- 
able is  to  estimate  the  rate.  When  one  has  become  fairly  famil- 
iar with  bond  valuations  he  can  estimate  the  rates  involved  with 
some  degree  of  accuracy.  In  order  to  finally  determine  the 
actual  rate,  however,  several  estimates  are  usually  necessary; 
and  trials  are  made  until  the  correct  rate  is  finally  obtained. 

The  method  of  interpolation  used  in  logarithmic  tables  is  of 
considerable  aid  in  this  connection.  To  illustrate,  if  i  represents 
the  rate  involved  in  the  valuation,  unknown,  and  A  the  present 
value  of  the  bond,  known;  then  (i)  an  estimate  of  the  rate  is 
made  at  i',  and  the  present  value  of  the  bond  A'  found  at  that 
rate ;  (2)  a  second  estimate  of  the  rate  is  made  at  rate  *"  and 
the  value  of  the  bond  A"  is  found  at  this  rate.  If  the  two  rates 
are  fairly  close  to  the  actual  rate,  the  following  ratio  is  approxi- 
mately true, 

i-i"        A-  A' 
i"  -i'~  A"  -  A' 
Therefore : 

A  —  A' 
(32)  i  =  i'  +        _        (i"  —  i')   (approximately) 

The  value  of  i  as  found  by  this  formula  will  usually  be  near 
enough  to  the  actual  rate  for  practical  purposes,  but  if  still  greater 
accuracy  is  desired  the  rate  thus  found  may  be  used  for  a  new 
trial  rate  and  the  same  operation  repeated.  By  continuing  to 
use  the  values  for  i  in  the  equation  for  new  trial  rates  several 
times,  the  rate  involved  will  be  obtained  to  a  greater  and  greater 
degree  of  accuracy. 

Suppose,  for  example,  that  a  twenty-year,  4  per  cent  bond  is 
sold  for  $1,109.66.  If  the  par  value  is  $1,000.00,  at  what  rate 


INTEREST  CALCULATIONS  385 

was  the  transaction  consummated  ?  The  rate  is  probably  some- 
where between  3  per  cent  and  3!  per  cent,  and  these  rates  may 
be  used  as  first  trial  rates.  The  value  at  3  per  cent  would  be 
$1,149.58,  and  at  3^  per  cent,  $1,071.49.  Using  formula  (32), 
then, 

,    (1,109.66  —  i,  149x8)  , 
"  •««  +  -  ^  -  ^>  -  3^55  % 


The  rate  thus  found,  3.255  per  cent,  although  not  the  actual  rate, 
is  probably  near  enough  for  practical  purposes.  In  case  greater 
accuracy  is  desired,  3.255  per  cent  may  be  used  as  a  new  trial 
rate  with  one  of  the  other  rates  and  the  process  repeated. 

This  same  method  of  interpolation  can  also  be  employed  in 
cases  where  the  interest  rate  involved  in  an  annuity  is  desired. 
Here  the  annuity  tables  are  of  particular  service.  The  annuity 
payments  and  present  value  are  both  known  but  the  interest  rate 
is  unknown.  Divide  the  present  value  figure  by  the  annuity 
payment  figure  and  the  dividend  is  the  present  value  of  one  dollar 
per  year  at  the  unknown  rate  of  interest.  Look  in  Table  IV  for 
the  two  quantities  which  most  nearly  correspond  to  this  figure 
for  the  same  number  of  periods.  Then  interpolate  between  the 
interest  rates  for  these  two  quantities  and  the  result  is  the  ap- 
proximate interest  rate. 

Suppose,  for  example,  that  the  X  Company  is  a  mining  con- 
cern. It  has  $100,000.00  of  capital  stock  outstanding  on  which 
it  is  paying  a  12  per  cent  dividend.  It  has  just  been  determined 
that  this  dividend  rate  can  be  maintained  for  a  period  of  ten  years 
in  the  future,  after  which  the  mine  is  exhausted  and  the  stock 
will  be  worthless.  Suppose  further  that  it  is  agreed  that  no  fund 
shall  be  maintained  to  redeem  the  stock  at  the  end  of  the  ten 
years.  The  stock,  from  the  point  of  view  of  the  investors,  is 
then  a  ten-year  annuity  of  $12,000.00  per  year.  Now  an  in- 
vestor with  all  these  facts  at  hand  purchases  $10,000  par  value 
of  this  stock  for  $10,368.09.  What  rate  of  interest  does  he  make 
on  the  investment?  The  $10,368.09  is  the  present  value  of  an 
annuity  of  $1,200.00  per  year  for  ten  years.  Dividing  the  first 
figure  by  the  second  gives  $8.6400761  ,  and  this  is  the  present  value 
of  one  dollar  per  year  for  ten  years  at  the  unknown  rate.  Re- 
ferring now  to  Table  IV,  it  may  be  seen  that  the  nearest  quan- 

2C 


386  PRINCIPLES  OF  ACCOUNTING 

tities  to  this  figure  for  ten  periods  are,  8.7520639  and  8.5302028 
at  the  rates  of  2^  per  cent  and  3  per  cent  respectively.  Then, 

i  —  .025  8.6400761  —  8.7520639 

.03  -  .025  8.5302028  -  8.7520639 

i  —  .025  —  .1119878 

.005  —.2218611 

Solving  this  for  i  the  result  is, 

i  =  .02752  or  2.75  per  cent  approximately. 

The  investor  then  will  realize  2|  per  cent  on  his  investment.  A 
similar  situation  arises  whenever  a  return  on  a  security  depends 
on  revenue  from  a  wasting  asset  and  no  depreciation  fund  is 
maintained  to  reimburse  the  stockholders  at  the  termination  of 
the  enterprise. 

Most  other  cases  in  which  the  interest  rate  is  the  unknown 
factor  are  relatively  simple  and  may  be  solved  either  directly 
from  the  formulae  given  in  the  early  part  of  the  chapter  or  by 
interpolation  with  the  aid  of  tables  as  just  illustrated. 

The  formulae  presented  in  the  foregoing  discussion  cover  the 
more  important  problems  in  interest  calculations.  No  attempt 
has  been  made  to  discuss  the  more  intricate  and  complex  prob- 
lems that  occasionally  arise  as  those  questions  belong  more  par- 
ticularly to  the  field  of  actuarial  science  than  to  accounting. 
Sufficient  examples  have  been  given,  however,  to  illustrate  the 
computations  involved  in  the  ordinary  transactions  met  with  in 
accounting  practice. 


XVII 

INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS 

THE  mathematical  formulae  discussed  in  the  last  chapter  are 
of  a  sufficiently  general  nature  to  be  applied  to  accounting  prob- 
lems of  very  different  types.  They  can  be  used  in  connection 
with  contractual  interest  transactions  affecting  both  sides  of  the 
balance  sheet.  This  chapter  will  be  devoted  to  a  consideration 
of  the  transactions  involving  contractual  interest  particularly 
from  the  point  of  view  of  the  equities.  In  such  cases  interest  is 
an  accrued  deduction  from  net  revenue  in  favor  of  the  equities 
whose  claims  are  listed  among  the  fixed  capital  items  on  the  equity 
side  of  the  balance  sheet.  The  ordinary  situations  which  present 
themselves  in  the  issuing  of  the  typical  forms  of  securities  will 
be  considered,  and  frequent  reference  will  be  made  to  the  math- 
ematical discussions  of  the  preceding  chapter. 

LONG-TERM  NON-INTEREST   BEARING  NOTES 

Non-interest  bearing  notes  are  frequently  used  for  borrowing 
in  ordinary  commercial  transactions.  Notes  of  this  character  are 
usually  of  the  short-term  type,  that  is  for  thirty,  sixty,  or  ninety 
days.  Their  accounting  treatment,  already  considered  in  an  earlier 
chapter,  is  relatively  simple.  Long-term  non-interest  bearing 
notes,  while  very  seldom  used  in  practice,  present  certain  ques- 
tions of  sufficient  importance,  however,  to  warrant  special  men- 
tion. 

A  corporation  might  find  it  convenient,  for  example,  to  raise 
capital  by  issuing  a  five-year,  non-interest  bearing  $10,000.00  note. 
The  only  advantage  of  such  a  procedure  would  lie  in  the  fact 
that  no  cash  payment  would  be  required  on  the  contract  from  the 
date  of  issue  until  the  date  of  maturity.  Interest  would  accumu- 
late, however,  in  each  accounting  period,  the  amount  depending 

387 


388  PRINCIPLES  OF  ACCOUNTING 

on  the  rate  involved  in  the  original  sale.  The  investor  would 
give  $7,440.94  for  this  note  if  the  rate  of  interest  involved  were 
6  per  cent,  convertible  semiannually.1  The  entries  on  the  cor- 
poration's books  at  the  date  of  issue  would  therefore  be, 

Cash $7,440.94 

Discount 2,559.06 

Notes  Payable $10,000.00 

These  entries  recognize  the  receipt  of  cash  in  exchange  for  a 
promise  to  pay  a  larger  sum  at  a  future  date,  the  difference  be- 
tween the  two  amounts  being  placed  in  a  valuation  account. 
The  investment  at  the  outset  is  $7,440.94,  and  as  interest  accrues 
at  the  rate  of  6  per  cent  it  amounts  to  $223.23  during  the  first 
half  year,  and  the  entries  at  that  time  would  be, 

Interest $223.23 

Discount       $223.23 

The  charge  to  interest  shows  an  accrual  of  $223.23  in  favor  of  the 
noteholder,  and  since  no  payment  is  made,  the  equity  itself  in- 
creases. This  increase  in  equities  is  recognized  by  the  credit 
to  Discount,  for  a  credit  to  Discount  reduces  this  valuation 
account  and  this  in  effect  increases  the  equity.  Taken  together 
the  Notes  Payable  and  Discount  accounts  now  show  the  present 
investment  ($7,664.17).  The  interest  accrual  during  the  second 
half  year  on  this  amount  would  be  recorded  as  follows, 

Interest $229.92 

Discount $229.92 

The  entries  for  each  succeeding  period  would  be  made  in  like 
manner  until  the  end  of  the  fifth  year,  at  which  time  the  entries 
recognizing  the  interest  accrual  would  be, 

Interest $291.26 

Discount $291.26 

The  original  charge  to  the  Discount  account  would  now  be  re- 
duced to  zero,  and  this  means  that  the  equity,  notes  payable, 

1  See  formula  (13),  Chapter  XVI,  for  the  method  of  obtaining  the  present  value 
of  a  sum  due  at  a  future  date.  Table  II  is  of  service  in  this  case. 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      389 


now  stands  at  par.     Since  the  note  must  be  paid  at  this  time  the 
additional  entries, 

Notes  Payable $10,000.00 

Cash $10,000.00 

would  now  be  made. 

Thus  the  only  transactions  with  the  investor  directly  are  the 
one  at  the  beginning  of  the  first  year  and  the  one  at  the  end  of  the 
last  year.  The  first  transaction  recognizes  an  investment  and 
an  equity  claim  of  $7,440.94,  the  last,  the  payment  of  an  equity 
claim  of  $10,000.00.  The  entries  for  the  intervening  period  ex- 
plain how  the  equity  actually  increased  from  the  former  to  the 
latter  figure.  The  following  table  shows  in  detail  how  the  change 
occurs.  Column  (2)  shows  the  investment  at  the  beginning  of 
each  period ;  column  (4)  the  investment  at  the  end  of  each 
period ;  and  column  (3)  the  interest  accrual  which  is  also  the  in- 
crease in  the  investment.  On  the  books,  the  investment  is  found 
in  each  case  by  deducting  the  balance  in  the  Discount  account 
from  the  credit  of  $10,000.00  in  Notes  Payable. 


(I) 

HALF-YEAR  PERIOD 

(2) 

PRESENT  VALUE  BE- 
GINNING OF  PERIOD 

(3) 
INTEREST 

(4) 
ACCUMULATION 

I 

$7,440.94 

$     223.23 

$7,664.17 

2 

7,664.17 

229.92 

7,894.09 

3 

7,894.09 

236.82 

8,130.91 

4 

8,130.91 

243-93 

8,374-84 

5 

8,374-84 

25I-25 

8,626.09 

6 

8,626.09 

258.78 

8,884.87 

7 

8,884.87 

266.55 

9,151.42 

8 

9,151.42 

274-54 

9,425.96 

9 

9,425.96 

282.78 

9,708.74 

10 

9,708.74 

291.26 

IO,OOO.OO 

Total 

$2,t;[;o  06 

w^)O  OV 

The  equity  of  the  noteholder  is  thus  shown  to  increase  steadily 
from  $7,440.94  to  $10,000.00,  and  good  financing  would  demand 
of  the  corporation  that  its  assets  available  for  liquidating  this 
note  should  also  increase  by  the  same  amount.  That  is,  the 


3QO  PRINCIPLES  OF  ACCOUNTING 

credits  to  Net  Revenue  from  operation  should  always  be  suffi- 
cient to  cover  the  interest  debits.  If  this  is  not  the  case,  the 
capital  invested  by  the  noteholder  is  impaired.  It  is  true  that 
he  has  no  claim  for  these  accruals  until  the  note  is  due,  but  failure 
on  the  part  of  the  corporation  to  earn  the  necessary  amount  does 
represent  an  impairment  of  capital.  The  total  par  of  the  note 
must  be  paid  at  maturity  in  any  event,  and  if  the  interest  ac- 
cruals are  not  earned  they  must  be  met  out  of  surplus  —  the 
stockholders'  equity. 

In  case  the  date  for  closing  the  accounts  and  making  statements 
should  not  coincide  with  one  of  the  conversion  dates  for  interest, 
accuracy  of  statement  requires  another  adjustment  in  the  ac- 
counts. Suppose,  for  example,  that  the  five-year  note  just 
mentioned  had  been  issued  March  3ist,  making  the  dates  of  con- 
version March  3ist  and  September  3oth,  and  that  the  date  for 
closing  the  accounts  was  December  3ist.  It  would  then  be 
necessary  to  make  an  entry  covering  the  interest  accrual  from 
September  3oth  to  December  3ist  each  year.  The  amount  of 
this  accrual  theoretically  should  be  found  from  formula  (4) .  For 
the  end  of  the  first  year  it  would  be, 

5  =  7,664.17  d  +  .03)* 
=  7,664.17  (1.0148892) 
=  7,778.28 

The  amount  of  the  interest  would  be  $7,778.28  minus  $7,664.17 
or  $114.11 ;  and  the  journal  entries  would  be, 

Interest $114.11 

Discount $114.11 

This  entry  would  cause  Net  Revenue  to  be  charged  with  the  in- 
terest actually  accruing  in  the  period  ending  December  3ist, 
and  would  increase  the  equity  item,  notes  payable,  to  its  current 
status.  Then  at  the  next  interest  conversion  date,  March  3ist, 
the  entries  should  recognize  the  interest  accruing  for  the  remain- 
ing three  months.  This  amount  is  found  in  the  same  manner  as 
that  for  the  preceding  three  months,  and  the  entries  are, 

Interest $115.81 

Discount $115.81 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      391 

The  two  entries,  one  for  $114.11,  and  one  for  $115.81,  make  up 
the  total  interest  accrual  ($229.92)  for  the  conversion  period  of 
six  months  as  shown  by  the  table.  Each  year  throughout  the 
life  of  the  note,  the  March  3ist  interest  accrual  would  be  ap- 
portioned between  the  two  accounting  periods  on  this  basis. 

In  actual  practice  the  bookkeeper  would  generally  prefer  to 
accrue  interest  on  the  simple  interest  basis  for  the  three  months 
rather  than  to  use  compound  interest  for  a  fraction  of  the  con- 
version period  as  was  done  here.  His  reason  for  this  is  two-fold. 
First,  it  is  much  easier  to  compute  the  interest  at  the  simple  rate 
than  at  the  compound  rate.  In  the  illustration  given  it  would 
mean  the  simple  division  of  the  six  months'  interest  by  two. 
This  result  would  be  charged  to  Interest  at  each  date,  the  same 
entries  being  made  December  3ist  and  March  3ist, 

Interest $114.96 

Discount $114.96 

In  the  second  place  the  difference  between  the  two  figures  is  so 
slight  as  to  be  of  little  importance  to  any  of  the  equities  involved. 
The  difference  here,  for  example,  is  that  when  the  accurate 
method  is  used  the  December  3ist  entry  is  85  cents  less  and  that 
of  March  3ist  is  85  cents  more  than  when  the  entries  are  made 
equal  by  the  bookkeeper's  usual  method.  Yet  although  such  a 
small  error  on  a  $10,000.00  note  is  of  little  significance,  in  order 
to  be  theoretically  correct  the  first  method  should  be  used. 


ANNUITIES 

Corporations  in  America  have  not  as  a  general  rule  resorted  to 
the  practice  of  issuing  formal  annuities  for  the  purpose  of  raising 
capital.  The  chief  reason  for  this  fact  is  that  it  has  been  con- 
venient to  finance  through  bond  issues  and  the  public  is  much 
more  familiar  with  bonds  as  an  investment  security  than  with 
annuities.  Annuities  are,  however,  a  convenient  form  of  security 
for  certain  kinds  of  investment  such  as  trust  funds  or  estates, 
and  there  seems  to  be  at  present  a  tendency  on  the  part  of  cor- 
porations to  cater  to  this  market.  This  tendency  is  evidenced 
by  the  extensive  use  of  serial  bonds.  Such  securities  are  prac- 
tically but  one  step  removed  from  annuities. 


392  PRINCIPLES  OF  ACCOUNTING 

In  addition  to  such  definite  annuities,  however,  there  are  a  great 
many  contracts  which  involve  annuity  computations.  The 
purchase  of  leaseholds  which  bear  an  annual  rental  for  a  defi- 
nite number  of  years,  copyrights  with  a  definite  royalty  pay- 
ment, etc.,  are  cases  in  point.  The  accounting  treatment  of 
such  items  often  involves  many  questions  of  theory  and  a  special 
chapter  has  been  devoted  to  these  topics.  But  the  annuity 
aspects  of  these  items  are  alike  in  character  and  can  be  ex- 
plained by  the  use  of  an  illustration  of  a  definite  annuity  con- 
tract. 

.  The  A.  B.  Co.',  a  corporation,  promises  to  pay  $20,000.00  per 
year  for  five  years,  the  amounts  to  be  paid  in  semiannual  install- 
ments, in  exchange  for  some  asset  received.  The  asset  received 
may  be  cash,  a  patent,  a  leasehold,  or  what  not,  as  explained  in 
the  preceding  paragraph.  For  purposes  of  illustration  it  may  be 
assumed  that  the  asset  received  is  cash.  The  amount  received 
would  obviously  be  the  present  value  of  the  annuity  at  the  market 
rate  of  interest  for  the  class  of  security  involved.  In  case  some 
other  form  of  property  were  received,  the  value  of  the  property 
item  would  also  be  the  present  value  of  the  annuity  at  the  market 
rate  of  interest.  The  property  account,  Cash  in  this  illus- 
tration, would  therefore  be  charged  with  the  amount  received 
as  determined  by  the  process  of  valuation  shown  in  formula  (21) 
of  the  preceding  chapter.  If  the  rate  involved  were  5  per  cent 
convertible  semiannually,  this  value  would  be  $87,520.64.  The 
company  receives,  then,  $87,520.64  and  promises  to  repay 
$100,000.00  during  the  succeeding  five  years.  The  difference 
between  the  two  quantities  given. is,  of  course,  interest.  The 
interest  accrues  during  the  intervening  period  and  should  be 
apportioned  among  the  various  net  revenue  statements  prepared. 
The  original  entries  at  the  date  of  issue  would  be, 

Cash       $87,520.64 

Discount  on  Annuity 1 2,479.36 

Annuity  Payable $100,000.00 

Discount  on  Annuity  is  a  valuation  account,  offsetting  the  lia- 
bility account  Annuity  Payable  which  shows  par  rather  >than 
present  value.  At  this  date  the  annuity  holder's  equity  in  the 
assets  is  $87,520.64,  but  the  par  value  of  all  the  annuity  coupons 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      393 

is  $100,000.00  —  hence  the  necessity  for  a  valuation  account. 
The  account  Annuity  Payable  is  used  here  to  indicate  the  equity 
item.  If  the  transaction  is  of  a  different  type  the  name  used  for 
this  credit  would  of  course  be  different.  Thus  it  might  be 
Leasehold  Payable,  Royalties  Payable,  etc.,  depending  on  the 
nature  of  the  contract.  The  annuity  might  even  consist  of  a 
series  of  notes,  non-interest  'bearing,  all  covered  by  the  same 
security.  In  this  case  the  Notes  Payable  account  would  be  used. 
At  the  end  of  six  months,  the  first  payment  of  $10,000.00  is 
made  and  the  entries  would  be, 

Annuity  Payable $10,000.00 

Cash $10,000.00 

Interest  has  accrued  up  to  this  time  amounting  to  2\  per  cent  on 
the  original  value,  or  $2,188.02  ;  and  this  amount  must  be  charged 
to  Net  Revenue  for  the  period.  The  entries  are, 

Interest  ...... $2,188.02 

Discount  on  Annuity  ....  $2,188.02 

This  reduces  the  balance  in  the  valuation  account,  Discount  on 
Annuity,  from  $12,479.36  to  $10,291.34,  and  the  net  equity  is 
shown  by  the  difference  between  this  figure  and  the  $90,000  re- 
maining in  Annuity  Payable,  or  $79,708.66.  The  interest  ac- 
crual for  the  next  period  is  2\  per  cent  of  this  amount  or  $1,992.72, 
and  the  entries  at  the  end  of  the  period  would  be  the  same  as  for 
the  preceding  accrual  except  for  the  amount  of  interest  involved. 
This  procedure  is  followed  at  each  payment  date  throughout  the 
life  of  the  annuity  and  at  the  end  of  the  fifth  year  the  balance  of 
the  Discount  on  Annuity  account  is  reduced  to  zero.  The 
amount  of  interest  at  each  date  may  be  found  from  the  fourth 
column  of  the  table  on  page  377  in  the  preceding  chapter. 

The  Annuity  Payable  account  will  always  have  a  credit  balance 
equal  to  the  par  value  of  the  unpaid  annuity  installments  and  the 
equity  of  the  annuity  holder  is  always  the  difference  between  this 
balance  and  the  Discount  on  Annuity  balance.  In  some  cases  it 
might  be  advisable  to  show  the  net  equity  in  the  Annuity  Payable 
account  and  therefore  not  use  the  discount  account  at  all.  Fol- 
lowing this  procedure  in  the  example  given,  the  entries  at  the  date 
of  issue  would  be, 


394  PRINCIPLES  OF  ACCOUNTING 

Cash •  .  $87,520.64 

Annuity  Payable $87,520.64 

The  only  objection  to  this  procedure  lies  in  the  fact  that  at  no 
place  does  the  total  liability  on  account  of  the  annuity  appear, 
and  it  is  quite  desirable  to  have  this  information  presented  in  the 
balance  sheet  in  some  form. 
The  entries  at  the  first  payment  date  in  this  case  would  be, 

Annuity  Payable $7,811.98 

Interest 2,188.02 

Cash $10,000.00 

These  entries  reduce  the  balance  of  Annuity  Payable  to  the 
present  value  of  the  remaining  payments,  and  charge  net  revenue 
with  the  interest  accrual.  The  same  procedure  would  be  fol- 
lowed for  each  subsequent  payment  date  until  the  last.  This 
would  reduce  the  balance  of  Annuity  Payable  to  zero. 

When  the  dates  for  closing  the  accounts  differ  from  the  dates 
of  the  annuity  payments,  it  becomes  necessary  to  enter  the  in- 
terest accruing  from  the  last  payment  date  to  the  closing  date. 
Suppose,  for  example,  that  the  annuity  mentioned  above  was 
issued  October  ist  and  that  the  books  are  closed  December  3ist. 
The  first  payment  will  not  be  made  until  March  ist,  but  interest 
accrues  at  the  rate  of  5  per  cent  convertible  semiannually  for 
three  months.  The  total  accumulation  by  formula  (4)  would  be, 

5  =  87,520.64  (i  +  .025)* 
=  87,520.64  (1.012423) 
=  88,607.90 

The  interest  accrued  would  be  $88,607.90  minus  $87,520.64,  or 
$1,087.26,  and  the  entries,  if  the  first  method  of  accounting  for 
the  annuity  were  used,  would  be, 

Interest $1,087.26 

Discount  on  Annuity  ....  $1,087.26 

The  amount  of  the  interest  accruing  for  the  following  three 
months,  up  to  the  next  payment  date,  may  be  found  by  the  same 
method  to  be  $1,100.76,  and  this  accrual  calls  for  similar  entries. 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      395 

On  this  date,  however,  a  payment  of  $10,000.00  is  made  and 
the  regular  entry  recording  this  payment  must  be  made. 

Here  again  it  is  customary  to  use  the  simple  rate  instead  of  the 
compound  rate  in  accruing  interest  between  payment  dates. 
That  is,  instead  of  finding  the  compound  interest  for  the  three 
months  ending  December  3ist,  as  was  done  in  the  illustrations, 
simple  interest  for  the  period  at  the  rate  of  5  per  cent  per  year 
would  be  used.  This  computation  would  give  $1,094.01.  The 
justification  for  this  practice  is  its  obvious  simplicity  as  compared 
with  the  other  method,  together  with  the  fact  that  the  amount 
of  the  error  is  relatively  small. 

BONDS   ISSUED    AT  PAR 

Bonds  are  the  most  common  form  of  security  for  raising  capital 
exclusive  of  capital  stock.  The  nature  of  the  bond  is  quite 
familiar.  It  consists,  as  was  shown  in  the  preceding  chapter 
(and  earlier  in  the  text),  of  two  promises  to  pay  :  (i)  a  principal 
sum  at  a  future  date ;  and  (2)  an  annuity  in  the  form  of  bond 
interest  payable  from  date  of  issue  until  the  par  is  due.  Failure 
to  recognize  this  two-fold  nature  of  the  bond  contract  has  often 
been  the  cause  of  rather  serious  accounting  errors,  especially  in 
cases  where  bonds  have  been  issued  either  at  a  discount  or  at  a 
premium.  It  would  be  entirely  possible  to  make  the  entries 
covering  the  two  parts  on  separate  bases  by  treating  the  par  of 
the  bond  as  a  long-term  non-interest  bearing  note,  as  was  shown 
in  the  first  section  of  the  chapter,  and  the  bond 'interest  as  an 
annuity,  as  was  shown  in  the  preceding  section.  Entirely 
accurate  results  would  be  obtained  from  this  procedure.  It  is 
possible  and  much  more  convenient,  however,  to  treat  the  bond 
as  a  unit  in  the  accounts.  Further,  it  is  desirable  to  keep  the 
information  in  regard  to  this  equity  in  one  account  since  the  right 
to  property  and  net  revenue  is  vested  in  a  single  contractual 
claim.  Current  accounting  practice,  therefore,  is  to  be  preferred, 
if  it  does  not  lead  to  a  misinterpretation  of  the  facts. 

The  advantage  of  treating  the  bond  as  a  whole  is  particularly 
evident  when  the  bond  is  issued  at  par.  In  this  case  the  present 
value  of  the  par  plus  the  present  value  of  the  bond  interest  pay- 
ments is  just  equal  to  par,  and  each  annuity  payment  just  cancels 


3Q6  PRINCIPLES  OF  ACCOUNTING 

the  accrued  interest  for  the  period.  The  bond  is  issued  at  par 
when  the  bond  rate  of  interest  and  the  market  rate  are  the  same. 
Thus,  a  4  per  cent,  $1,000.00,  five-year  bond,  interest  payable 
semiannually,  would  bring  par  if  the  market  rate  were  4  per  cent 
convertible  semiannually.  The  journal  entries  at  the  date  of 
issue  would  be, 

Cash $1,000.00 

Bonds $1,000.00 

The  $1,000.00  entry  in  the  Bonds  account  represents  the  pres- 
ent value  of  the  bondholder's  equity  as  represented  in  his  claim 
for  $1,000.00  at  the  end  of  five  years,  and  for  ten  payments  of 
$20.00  each  every  six  months.  The  total  claim  is  for  $1,200.00, 
but  the  present  value,  $1,000.00,  is  entered  in  the  account.  This 
is  the  customary  method  of  recording  the  original  issue  of  bonds 
at  par,  and  it  will  readily  be  seen  that  this  is  simpler  than  record- 
ing the  sum  of  all  payments  in  the  Bonds  account  when  it  comes 
to  recognizing  the  bond  interest  payments.  At  the  end  of  six 
months  the  interest  accrued  on  the  amount  invested  at  the  mar- 
ket rate  (4  per  cent)  is  $20.00.  The  bondholder  is  paid  $20.00  on 
his  contract  at  this  time,  however,  so  that  the  bond  interest  pay- 
ment just  offsets  the  interest  accrual.  The  only  entries  neces- 
sary, therefore,  are, 

Interest $20.00 

Cash $20.00 

Since  the  aqcrual  of  interest  will  be  equal  to  the  bond  interest 
payment  at  each  payment  date,  these  same  entries  will  be  suffi- 
cient at  each  date.  The  credit  in  the  Bonds  account  then  will 
remain  steadily  at  $1,000.00,  this  figure  representing  the  present 
value  of  all  future  payments  at  each  payment  date  as  well  as  par. 
After  the  last  bond  interest  payment,  the  Bonds  account  will  still 
be  stated  at  par,  but  the  par  of  the  bond  is  immediately  paid  and 
the  entries, 

Bonds $1,000.00 

Cash $1,000.00 

close  the  transaction. 

It  was  said  that  this  method  is  simpler  than  it  would  be  to 
credit  the  total  of  all  payments  to  the  Bonds  account  at  the  date 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      397 

of  issue.  This  is  what  would  be  done  if  the  two  parts  of  the  bond 
were  treated  separately.  It  will  be  worth  while,  however,  to 
consider  the  entries  which  would  be  made  according  to  such  a 
method.  In  the  first  place,  the  total  of  all  the  payments,  $1,200.00, 
would  be  credited  to  the  Bonds  account.  But  only  $1,000.00  is 
received  in  cash,  the  other  $200.00  is  the  interest,  and  not  yet 
accrued ;  or,  looked  at  in  another  light,  this  amount  may  be  con- 
sidered as  the  total  discount  on  all  payments.  The  entries  at 
the  date  of  issue  would  be, 

Cash       $1,000.00 

Discount 200.00 

Bonds $1,200.00 

The  Discount  account  is  again  a  valuation  account  offsetting  the 
overstatement  of  the  equity  item,  Bonds.  The  difference  be- 
tween these  two  accounts  represents  the  present  equity  of  the 
bondholder.  At  the  end  of  six  months  interest  would  have  ac- 
crued on  this  equity  at  the  rate  of  4  per  cent  amounting  to  $20.00. 
This  requires  a  charge  to  Interest  and  a  credit  to  the  valuation 
account,  thus: 

Interest $20.00 

Discount $20.00 

But  a  cash  payment  is  made  to  the  bondholder  amounting  to 
$20.00,  hence  the  additional  entries, 

Bonds $20.00 

Cash $20.00 

would  be  made.  The  Bonds  account  now  shows  a  balance  of 
$1,180.00,  this  being  the  total  of  the  remaining  payments.  At 
the  same  time  the  balance  in  the  Discount  account  is  $180.00. 
Deducting  this  item  from  the  balance  in  the  Bonds  account  leaves 
$1,000.00,  the  present  value  of  the  remaining  payments.  Inter- 
est on  this  figure  for  the  next  period  of  six  months  would  again 
be  $20.00,  and  a  payment  of  $20.00  would  be  made  at  the  end  of 
the  period  necessitating  the  same  entries  as  before.  Again  this 
would  leave  the  net  value  of  the  equity  at  $1,000.00.  The  same 
entries  would  then  be  made  at  the  end  of  each  period  until  the 
tenth.  This  process  would  reduce  the  Discount  balance  to  zero, 
and  at  this  time  also  the  par  of  the  bonds  would  be  paid. 


398  PRINCIPLES  OF  ACCOUNTING 

This  latter  method  of  handling  the  Bonds  account,  while  sel- 
dom or  never  used  in  practice,  illustrates  quite  clearly  the  nature 
of  the  bond  contract,  and  calls  particular  attention  to  the  fact 
that  the  par  value  figure  is  not  of  as  great  significance  as  the 
present  value  of  the  future  payments.  Still  the  simplicity  of  the 
first  method  of  accounting  is  sufficient  to  commend  it  for  general 
use  where  bonds  are  issued  at  par. 

It  was  assumed  in  the  above  illustrations  that  the  bonds  were 
sold  on  the  date  of  issue,  that  is,  that  the  dating  on  the  bonds 
was  determined  by  the  date  the  bonds  were  sold  to  investors. 
Very  frequently  in  practice  this  is  not  the  case.  The  total  issue 
of  a  series  of  bonds  bears  the  same  date  of  issue,  and  the  same 
interest  payment  dates,  although  the  sales  to  investors  are  made 
at  various  dates.  When  the  bonds  are  sold  between  regular  in- 
terest payment  dates,  accrued  interest  to  the  date  of  sale  must  be 
taken  into  account. 

Suppose,  for  example,  that  the  series  of  bonds  in  which  the  one 
in  the  preceding  illustration  was  included  were  issued  as  of 
March  3ist,  1918.  Then  the  interest  payment  dates  would  be 
September  3oth  and  March  3ist,  and  the  par  would  be  payable 
March  3ist,  1923.  Now  the  separate  bonds  might  all  be  sold 
on  March  3ist,  1918,  in  which  case  the  entries  would  be  the  same 
as  those  given  above ;  or  they  might  be  sold  in  quantities  at 
various  dates  after  March  3ist  with  accrued  interest  from  that 
date.  In  the  present  illustration  the  bonds  were  issued  at  par, 
and  if  a  $1,000.00  bond  of  this  series  were  sold  on  June  3oth  with 
accrued  interest,  the  amount  of  cash  received  should  be  found 
by  formula  (4),  which  is, 

S  =  P(i  +  j/m}™ 

In  this  case  P  would  be  the  present  value  at  the  preceding  interest 
payment  date  ($1,000.00) ;  j,  the  market  rate  of  interest  (.04) ; 
m,  the  number  of  conversions  (2) ;  and  n,  the  number  of  years 

(•j).     Therefore,  c  .  a 

S  =  1,000.00  (i  +  .02)* 

=  1,000.00  (1.009951) 
?=  1,009.95 

The  accrued  interest  then  at  this  time  is  $9.95.  The  entries  re- 
cording the  sale  of  the  bond  would  therefore  be, 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      399 


Cash $1,009.95 


Bonds 
Interest 


$1,000.00 
9-95 


The  accrued  interest  item  is  credited  directly  to  the  net  revenue 
account,  Interest,  though  no  interest  has  been  earned  by  the  in- 
vestor at  this  time.  As  a  matter  of  fact  the  $9.95  is  a  part  of 
the  bondholder's  investment  which  is  returned  in  the  first  bond 
interest  payment.  This  fact  can-  be  clearly  shown  by  taking 
the  viewpoint  of  the  investor  for  a  moment.  He  has  invested 
$1,009.95  at  4  per  cent  convertible  semiannually,  and  receives 
a  payment  at  the  end  of  three  months.  His  investment  has 
accumulated  for  three  months  at  the  stated  rate,  hence  it  will 
amount  to, 

S  =  1,009.95  (i  +  .02)2 
=  1,020.00 

The  original  investment  was  $1,009.95  and  this  accumulated  to 
$1,020.00;  but  $20.00  is  paid,  and  this  reduces  the  investment 
to  $1,000.00.  The  interest  earned  by  the  investor  for  the  period 
is  $10.05  5  and  this  is  the  interest  chargeable  to  net  revenue  by 
the  corporation.  Now  since  $9.95  was  credited  to  Interest  at 
the  date  of  sale,  the  whole  $20.00  payment  on  September  3oth 
can  be  charged  to  Interest  in  order  to  produce  the  desired  net 
charge  to  this  account.  Then  on  September  3oth  the  entries 
would  be, 

Interest $20.00 

Cash $20.00 

The  net  result  of  the  entries  in  the  Interest  account  may  be  seen 
in  this  account  form. 

INTEREST 


Sept. 

30 

$20 

oo 

June 

30 

$9 

95 

The  $20.00  charge  on  September  3oth  offsets  the  $9.95  credit  of 
June  3oth,  and  leaves  a  net  balance  of  $10.05  on  tne  debit  side. 


400  PRINCIPLES  OF  ACCOUNTING 

This  is  as  it  should  be,  a  charge  against  Interest  for  the  accrual 
from  June  3oth  to  September  3oth. 

It  is  customary  in  practice  to  apportion  the  interest  accruing 
in  a  fractional  part  of  an  interest  conversion  period  on  a  propor- 
tional basis  rather  than  on  the  compound  rate  basis  as  shown 
here.  That  is,  instead  of  charging  $1,009.95  f°r  the  bond  in 
this  case,  the  company  would  have  charged  $1,010.00.  The 
$10.00  is  simple  interest  for  three  months  as  compared  with 
$9.95  if  the  true  compound  rate  were  used.  It  is  evident  that 
this  practice  works  to  the  disadvantage  of  the  investor  as  he 
fails  to  realize  the  compound  rate  on  his  investment  for  the  re- 
maining part  of  the  period  in  which  he  made  the  purchase.  The 
difference  is  small,  however,  and  therefore  the  investor  seldom 
objects  seriously  to  this  practice,  though  as  a  matter  of  accuracy 
the  compound  rate  should  be  used  as  was  illustrated. 

In  case  the  accounts  are  closed  at  dates  other  than  payment 
dates,  interest  again  must  be  accrued  for  the  fractional  periods 
involved.  To  illustrate  this  point,  suppose  that  the  books  of 
the  corporation  issuing  the  bond  in  the  illustration  above  were 
to  be  closed  on  December  3ist.  Then  interest  must  be  accrued 
and  entered  on  the  accounts  for  the  three  months  from  September 
3oth.  At  the  compound  rate  of  4  per  cent  convertible  semi- 
annually  this  would  amount  to  $9.95  and  the  entries  covering 
this  accrual  would  be, 

Interest $9-Q5 

Accrued  Interest $9-95 

The  Accrued  Interest  account  would  appear  on  the  balance 
sheet  as  a  liability.  Then  on  March  3ist,  when  the  next  payment 
is  made,  the  entries  would  be,1 

Interest $10.05 

Accrued  Interest 9.95 

Cash $20.00 

The  net  result  of  these  two  entries  is  to  place  $9.95  in  the  net 
revenue  sheet  of  the  accounting  period  ending  December  3ist 

1  Instead  of  using  the  Accrued  Interest  account  the  inventory  method  as  shown  in 
Chapter  VIII  might  be  used. 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      401 

and  $10.05  m  the  succeeding  period.     This  is  just  what  is  desired 
when  accounts  are  kept  on  the  accrual  basis. 


BONDS  ISSUED  AT  A  DISCOUNT 

In  the  preceding  section  the  simple  case  of  bonds  issued  at  par 
was  treated ;  but  bonds  are  very  seldom  issued  exactly  at  par. 
The  reason  for  this  is  the  fact  that  corporations  cannot,  or  at 
least  do  not,  usually  use,  the  market  rate  of  interest  for  the  bond 
rate  when  issuing  bonds.  It  is  difficult  to  determine  in  advance 
just  what  will  be  the  market  rate  for  a  given  issue  of  bonds,  and 
whenever  the  market  rate  is  different  from  the  bond  rate  the 
bonds  will  sell  either  at  a  discount  or  at  a  premium.  Both  of 
these  cases  present  certain  difficult  accounting  questions.  In  this 
section  the  problems  of  analysis  arising  in  connection  with  bond 
discount  will  be  considered. 

If  a  five-year,  4  per  cent,  $1,000.00  bond,  interest  payable  semi- 
annually,  were  offered  for  investment  on  a  market  which  called 
for  5  per  cent  convertible  semiannually,  the  price  would  be 
$956.24.  (See  formula  (30) ,  preceding  chapter.)  The  amount  of 
cash  received  at  this  time  by  the  corporation  is  $956.24  in  ex- 
change for  its  promise  to  pay  $1,200.00  (par  $1,000.00  and  bond 
interest  $200.00).  The  difference  between  the  amount  received 
and  the  total  promise  to  pay  is  interest,  $243.76 ;  and  the  same 
must  be  distributed  to  the  net  revenue  sheets  of  the  proper  years. 

Here  again  it  is  current  practice  to  credit  the  Bonds  account 
with  the  par  of  the  bonds  issued.  In  this  case,  however,  the  par 
does  not  also  represent  the  present  value.  This  fact  has  led  to  a 
great  deal  of  confusion  in  accounting  practice.  The  par  of  the 
bond  is  a  convenient  figure  to  carry  in  the  Bonds  account.  When 
the  bonded  indebtedness  of  a  corporation  is  mentioned,  for 
instance,  the  par  value  of  the  bonds  is  quoted,  and  the  total 
capitalization  is  often  referred  to  as  the  sum  of  the  par  values  of 
capital  stock  and  bonds.  Further,  in  case  of  failure  to  meet 
interest  payments  it  is  generally  recognized  that  the  bondholder's 
claim  on  the  mortgaged  property  is  for  the  par  value  of  his  bond. 
All  these  facts  tend  to  establish  current  practice  as  the  most 
logical  method.  But  —  and  here  is  where  confusion  usually 
arises  —  par  and  present  value  in  this  case  are  not  synonymous. 

2D 


402  PRINCIPLES  OF  ACCOUNTING 

Present  value  is  somewhat  less  than  par,  and  a  valuation  account 
must  be  kept  to  record  this  difference.  This  account  is  Dis- 
count on  Bonds.  The  proper  entries  at  the  date  of  issue  then  are, 

Cash $956.24 

Discount  on  Bonds 43-76 

Bonds $1,000.00 

It  is  the  nature  of  the  account  Discount  on  Bonds  that  seems 
to  cause  most  of  the  difficulty.  This,  as  was  just  stated,  is  a 
valuation  account  whose  function  is  to  offset  the  amount  entered 
in  the  Bonds  account  in  order  to  reduce  that  item  to  the  present 
status  of  the  equity  involved.  Many  peculiar  notions  arise  in 
connection  with  this  item  among  accountants  and  business  men. 
Sometimes  it  is  said  that  it  is  a  property  item.  The  argument 
for  this  contention  runs  something  like  this.  Discount  is  a  cost 
of  getting  capital ;  capital  is  just  as  essential  to  the  establish- 
ment of  an  enterprise  as  the  buildings,  machinery  and  other  struc- 
tures ;  engineers'  and  draftsmen's  salaries  paid  for  the  plans  for 
the  building  are  a  part  of  the  cost  of  the  structure,  and  are 
charged  to  property  accounts ;  therefore  as  discount  is  an  item 
akin  to  the  draftsman's  salary,  discount  is  a  property  item. 

There  are  two  very  obvious  answers  to  this  contention.  In 
the  first  place,  the  amount  of  discount  entered  in  this  account 
is  only  a  part  of  the  total  discount  on  the  issue.  The  total  dis- 
count is  the  difference  between  the  total  promises  and  the  present 
value,  $243.76,  while  the  amount  under  consideration  is  only  the 
difference  between  the  par  and  present  value,  $43.76.  If  this 
latter  amount  is  property,  then  why  not  all  of  the  discount? 
This  would  mean  that  all  of  the  interest  arising  during  the  life 
of  the  bond  would  be  charged  to  property,  but  no  one  would 
ever  urge  such  a  policy.  Again,  the  amount  of  discount  depends 
on  the  bond  rate  of  interest.  The  higher  the  bond  rate  of  in- 
terest, the  less  the  discount.  In  fact  if  the  bond  rate  is  high 
enough  there  will  be  a  premium  instead  of  a  discount,  and  who 
would  think  of  crediting  the  property  with  the  amount  of  the 
premium  ?  Yet  this  is  what  such  a  policy  would  logically  lead 
to  and  this  should  make  it  clear  that  discount  is  not  a  cost  of 
property,  but  an  interest  item. 

Another  error  consists  in  considering  discount  a  loss.     That 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      403 

is,  it  is  said  that  the  corporation  receives  $956.24  in  return  for 
a  promise  to  pay  $1,000.00  and  that  therefore  $43.76  was  lost 
in  the  deal.  One  can  answer  this  again  by  saying  that  the 
amount  of  $956.24  was  received  in  exchange  for  a  promise  to  pay 
$1,200.00,  therefore  $243.76  was  lost  in  the  transaction.  When 
stated  in  this  way,  the  absurdity  of  this  claim  is  obvious. 

The  present  value  of  the  bond,  then,  is  always  shown  by  the 
difference  between  the  par  as  shown  in  the  Bonds  account  and  dis- 
count as  shown  in  the  Discount  on  Bonds  account.  At  the 
date  of  issue  the  balance  sheet  items  representing  the  bond 
mentioned  above  would  show, 

Cash  (or  other  property  Bonds $1,000.00 

received  for  bonds)  .     .       $956.24 
Discount  on  Bonds      .     .          43 .76 

$1,000.00  $1,000.00 

Now  at  the  end  of  six  months,  a  payment  of  $20.00  is  made  for 
bond  interest.  There  has  accrued  during  the  same  period  i\ 
per  cent  of  the  original  investment  $956.24,  or  $23.91.  There 
has  accrued  in  favor  of  this  equity,  then,  $23.91,  and  but  $20.00 
is  paid  in  cash.  The  entries  would  be, 

Interest $23.91 

Cash $20.00 

Discount  on  Bonds 3.91 

The  credit  to  Discount  on  Bonds  reduces  the  balance  in  that 
valuation  account  and  hence  increases  the  net  valuation  of  the 
bondholder's  equity.  Assuming  that  there  was  sufficient  net 
revenue  to  cover  the  interest  charge  of  $23.91,  the  journal  entry 
made  at  this  time  actually  reserves  $3.91  in  property  for  the 
bondholder.  The  situation  as  regards  this  bond,  and  exclusive 
of  other  facts,  would  be, 

Property  (from  origi-  Bonds $1,000.00 

nal  issue)     .     .     .    $956.24 

Cash  (or  other  prop- 
erty retained)  .     . 


Discount  on  Bonds  . 

$1.000.00  $1,000.00 


404  PRINCIPLES  OF  ACCOUNTING 

The  present  value  of  the  bond  as  shown  by  this  statement  is 
$960.15.  The  bondholder's  equity  has  increased  by  $3.91  as 
compared  with  the  last  statement.  In  fact  it  might  be  said  that 
the  bondholder  has  made  a  new  loan  to  the  corporation  not  in 
the  form  of  cash  but  in  the  form  of  foregone  interest.  He  accepts 
less  in  cash  than  the  interest  accrual  on  his  investment.  At  the 
end  of  the  next  six  months'  period,  the  interest  accrued  on  the 
investment  since  the  beginning  of  the  period  at  2\  per  cent  would 
amount  to  $24.00,  and  the  entries  would  be, 

Interest       $24.00 

Cash $20.00 

Discount  on  Bonds 4.00 

The  results  of  these  entries  may  easily  be  traced  in  the  same 
manner  as  was  explained  above.  The  same  procedure  would 
be  followed  at  each  succeeding  interest  payment  date.  The 
amounts  for  each  entry  may  be  obtained  from  the  accumulation 
of  discount  table  shown  on  page  381.  Accumulation  tables  are 
always  of  service  in  making  entries  for  bonds  issued  below  par. 
In  case  the  bond  is  issued  between  interest  dates  at  a  discount 
the  method  of  entry  is  essentially  the  same  as  when  issued  at 
par,  as  was  illustrated  in  the  preceding  section.  Thus  suppose 
that  the  4  per  cent  bond  which  was  sold  on  a  5  per  cent  basis  had 
been  dated  March  3ist  as  before,  and  that  the  sale  was  made  on 
June  3oth.  In  this  case  the  selling  price  should  be  $956.24,  the 
price  at  the  preceding  interest  payment  date,  plus  interest  at  the 
rate  of  5  per  cent  convertible  semiannually  for  three  months, 
that  is, 

S  =  956.24  (i  +  .025)! 
=  956.24  (1.012423) 
=  968.12 

and  the  accrued  interest  is  $968.12  minus  $956.24  or  $11.88. 
The  entries  would  be, 


Cash $968.12 

Discount  on  Bonds 43-76 

Bonds $1,000.00 

Interest  n.88 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      405 

The  entries  at  the  first  interest  payment  date  would  then  be  the 
same  as  shown  above,  and  the  Interest  charge  of  $23.91  would 
offset  the  credit  to  interest  of  $11.88,  leaving  the  net  charge  to 
interest  for  the  period  at  $12.03.  Again  it  should  be  mentioned 
that  in  practice  such  precision  is  seldom  attained.  The  investor 
is  generally  charged  simple  interest  from  the  last  payment  date. 
In  this  case  simple  interest  would  amount  to  5  per  cent  of  $956.24 
for  three  months  or  $11.95.  The  bondholder  is  overcharged  8  cents 
on  this  plan  and  fails  to  earn  the  market  rate  during  the  succeed- 
ing three  months,  but  the  amount  of  the  overcharge  is  small  and 
may  be  considered  as  a  sort  of  commission  paid  for  the  service 
of  handling  the  funds. 

In  case  the  closing  date  falls  between  two  interest  payment 
dates,  accrued  interest  must  be  taken  into  account.  This  is 
done  in  the  same  manner  as  shown  in  the  preceding  section. 
The  accumulation  should  be  figured  at  the  market  rate  on  the 
book  value  at  the  preceding  interest  date.  Thus  in  order  to 
close  the  books  on  December  3ist  for  the  bond  just  mentioned, 
interest  must  be  accrued  on  the  June  3oth  figures,  $960.15,  at 
5  per  cent  convertible  semiannually  for  three  months.  This 
accrual  amounts  to  $11.93  and  the  entries  are, 

Interest       $11.93 

Accrued  Interest '    .  $11.93 

Then  on  March  3ist  when  the  bond  interest  is  paid  the  entries 
are, 

Accrued  Interest       $11.93 

Interest 12.07 

Cash $20.00 

Discount  on  Bonds 4.00 

These  latter  entries  cancel  the  Accrued  Interest  item  on  Decem- 
ber 3ist,  charge  Interest  with  the  accrual  since  that  date,  and 
write  off  the  proper  amount  of  discount  for  the  whole  period. 

BONDS   ISSUED  AT  A  PREMIUM 

Whenever  the  market  rate  at  which  a  bond  is  issued  is  less 
than  the  bond  rate  of  interest,  a  bond  sells  at  a  premium.  The 
present  value  of  all  the  promises  to  pay  involved  in  the  bond  con- 


406  PRINCIPLES  OF  ACCOUNTING 

tract  is  greater  than  the  par  value.  Here  again  it  is  customary 
to  credit  the  Bonds  account  with  just  the  par  value,  and  this 
practice  is  justified  by  the  same  reasoning  as  in  the  case  of  bonds 
sold  at  a  discount.  This  practice,  however,  has  also  led  to  in- 
correct analysis  in  many  cases.  The  difficulty  seems  to  lie  in  a 
failure  to  understand  the  nature  of  the  additional  amount  re- 
ceived above  par  for  the  bond.  For  example,  if  the  4  per  cent 
bond  used  in  the  preceding  illustration  were  issued  on  a  3  per 
cent  market  basis,  the  amount  of  cash  received  would  be  $1,046.11. 
The  premium  is  $46.11.  Just  what  is  the  nature  of  this  item? 
It  is  doubtless  clear  that  it  represents  a  part  of  the  present  value 
of  the  bond  —  a  part  of  the  investment  of  the  bondholder  —  just 
as  discount  in  the  preceding  case  constituted  a  deduction  from 
the  par  value  to  get  the  present  value  or  investment  of  the  bond- 
holder. The  amount  of  the  premium,  then,  should  be  credited 
to  an  equity  account,  the  proper  journal  entries  being, 

Cash ; $1,046.11 

Bonds $1,000.00 

Premium  on  Bonds      ....  46.11 

The  total  equity  of  the  bondholder  at  this  time  is  $1,046.11. 
This  is  the  present  value  of  the  total  of  all  promises  to  pay, 
$1,200.00.  The  difference  between  $1,200.00  and  $1,046.11  is 
the  total  interest,  or  in  other  words  it  is  the  amount  by  which 
the  total  payments  have  been  discounted. 

Particular  emphasis  is  placed  on  this  fact  because  frequently 
one  hears  it  said  that  the  premium  on  bonds  is  a  profit.  In  fact, 
cases  are  known  where  corporations  have  credited  the  premium 
on  bonds  to  revenue  or  to  surplus  accounts.  The  absurdity  of 
such  a  practice  seems  evident  as  this  would  mean  that  premiums 
received  are  revenue  items,  revenue  obtained  from  one's  own 
promise  to  pay.  One  might  venture  the  remark  that  if  revenue 
may  be  obtained  as  easily  as  this,  why  not  go  into  the  business  of 
issuing  bonds  ?  Surely  this  would  be  much  less  troublesome  than 
ordinary  industrial  operations.  All  that  would  be  necessary  to 
make  large  revenues  would  be  high  bond  interest  rates  in  com- 
parison with  the  market  rates,  for  the  amount  of  premium  de- 
pends on  the  bond  rate  of  interest  and  this  may  be  stated  at 
any  figure  suitable  to  the  management.  Evidently,  therefore, 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      407 

premium  on  bonds  is  not  a  revenue  but  is  part  of  the  original 
investment. 

Six  months  after  the  date  of  issue,  interest  accrues  to  the  ex- 
tent of  if  per  cent  on  the  original  investment.  This  accrual  is 
$15.69.  The  annuity  payment  on  this  date,  however,  is  $20.00, 
and  the  difference  between  these  two  amounts  is  a  return  of  part 
of  the  original  investment.  The  journal  entries  are, 

Interest $15.69 

Premium  on  Bonds 4.31 

Cash $20.00 

The  debit  of  $4.31  to  Premium  on  Bonds  reduces  the  balance  of 
that  liability  account.  The  present  value  of  the  bond  at  this 
date  is  the  sum  of  the  Bonds  account  balance,  $1,000.00,  and  the 
balance  in  Premium  on  Bonds,  $41.80,  or  $1,041.80. 

The  function  of  the  Premium  on  Bonds  account  can  perhaps 
be  shown  more  clearly  by  the  use  of  a  balance  sheet  statement. 
Taking  into  account  just  those  facts  relating  to  the  issue  of  this 
bond,  on  the  date  of  issue,  the  balance  sheet  would  show, 

Cash $1,046.11     Bonds $1,000.00 

Premium  on  Bonds    .     .  46.11 

$1,046.11  $1,046.11 

The  bondholder's  equity  is  shown  in  the  two  accounts  on  the  lia- 
bility side.  Now  at  the  end  of  six  months,  and  after  the  first 
$20.00  payment  is  made,  the  balance  sheet  would  show,  with 
respect  to  this  bond, 

Cash  (or  other  Property)  Bonds $1,000.00 

from  bond  issue      .     .    $1.041.80    Premium  on  Bonds    .     .  41.80 

$1,041.80  $1,041.80 

If  all  of  net  revenue  had  been  distributed,  these  statements 
would  show  the  fact  that  an  investment  of  $1,046.11  was  made, 
and  that  six  months  later  $4.31  was  returned  to  the  investor, 
leaving  the  net  investment  at  $1,041.80.  Interest  would  accrue 
during  the  following  half  year  at  the  rate  of  3  per  cent  on 
$1,041.80.  This  accrual  is  $15.63  and  the  entries  at  this  time 
would  be, 


408  PRINCIPLES  OF  ACCOUNTING 

Interest $15.63 

Premium  on  Bonds 4.37 

Cash $20.00 

This  procedure  carried  out  to  the  end  of  the  fifth  year  would 
reduce  the  balance  of  the  Premium  on  Bonds  account  to  zero. 
At  this  time  the  only  part  of  the  bondholder's  equity  remain- 
ing on  the  books  would  be  shown  in  the  Bonds  account  (par). 
The  bonds  would  now  be  retired  at  par  and  this  equity  would 
be  entirely  extinguished.  The  entries  to  be  made  during  the  life 
of  such  a  bond  can  easily  be  obtained  from  an  amortization  table 
similar  to  the  one  explained  on  page  383. 

In  case  a  bond  is  sold  at  a  premium  on  a  date  subsequent  to 
the  date  of  issue,  accrued  interest  is  charged  to  the  investor  from 
the  last  payment  date,  just  as  was  shown  in  the  preceding  sec- 
tion where  the  bond  was  sold  at  a  discount.  As  an  illustration 
suppose  that  a  5  per  cent  bond  due  May  ist,  1921,  interest  pay- 
able May  ist  and  November  ist,  is  sold  on  a  4  per  cent  basis  on 
August  ist,  1916.  The  value  of  the  bond  on  May  ist  at  4  per 
cent  is  $1,044.91,  and  the  August  ist  price  will  be  this  amount 
plus  interest  at  4  per  cent  for  three  months.  This  amount  may 
be  obtained  by  formula,  thus, 

5  =  1,044.91  (i  +  .02)2 
=  1,044.91  (1.009951) 
=  1,055.31 

This  price,  $1,055.31,  is  made  up  of:  (i)  par  $1,000.00; 
(2)  premium  May  ist,  $44.91 ;  and  (3)  accrued  interest  from  May 
ist  to  August  ist,  $10.40.  The  entries  at  date  of  sale  would  in- 
clude these  three  items. 

Cash $1,055.31 

Bonds $1,000.00 

Premium  on  Bonds      ....  44-Qi 

Accrued  Interest 10.40 

Three  months  later  when  the  semiannual  interest  payment  is 
made,  the  actual  payment,  though  called  semiannual  interest, 
will  really  include:  (i)  the  accrued  interest  item  as  shown  in 
this  entry;  (2)  the  interest  accruing  since  that  date,  $10.50; 
and  (3)  $4.10  on  the  premium.  The  entries  will  be, 


INTEREST  TRANSACTIONS  —  EQUITY   ACCOUNTS      409 

Accrued  Interest $10.40 

Interest 10.50 

Premium 4.10 

Cash $25.00 

The  Accrued  Interest  account  here  is  treated  in  the  same 
manner  as  was  shown  in  the  similar  case  for  bonds  sold  at  a  dis- 
count. Another  case  in  which  the  Accrued  Interest  account 
would  be  necessary  is  where  the  closing  date  is  different  from  the 
interest  payment  date.  The  treatment  of  this  case  is  analogous 
to  that  required  for  the  cases  already  shown  in  the  preceding 
section, 

THE   REFUNDING   OF   SECURITIES 

In  the  illustrations  of  securities  issued  under  various  conditions 
thus  far  given,  it  has  been  assumed  that  the  original  contract  is 
carried  out  to  the  date  of  maturity.  That  is,  if  a  4  per  cent  bond 
is  issued  on  a  5  per  cent  basis,  the  entries  were  shown  as  they 
would  normally  be  if  no  changes  took  place,  as  far  as  the  issuing 
company  is  concerned,  until  the  bonds  matured.  The  market 
rate  of  interest  used  for  determining  the  amount  charged  to  net 
revenue  remains  at  5  per  cent  throughout  the  whole  period. 
Some  question  might  arise  as  to  the  propriety  of  retaining  this 
original  computation  figure  throughout  the  whole  period.  Most 
bonds  are  issued  for  relatively  long  periods  of  time,  twenty, 
thirty,  fifty  and  even  ninety-nine  years.  Now  it  is  true  that  the 
general  market  rate  of  interest  changes  during  such  periods,  so 
that  were  the  company  to  issue  the  same  bonds  at  some  later 
period,  the  interest  rate  would  be  different.  Why  then  main- 
tain the  old  5  per  cent  market  rate  in  the  face  of  such  changing 
market  conditions?  At  first  thought  it  might  appear  that  this 
is  in  contradiction  to  the  general  viewpoint  emphasized  in  this 
text  that  the  accounts  should  always  be  sensitive  to  price  change. 
Market  conditions  should  be  reflected  in  the  accounts  as  soon  as 
possible.  Yet  this  contradiction  is  only  apparent,  for  this  situa- 
tion is  not  analogous  to  the  general  situations  emphasized  in 
other  connections.  Here  there  is  a  definite  contract  entered 
into  between  the  corporation  and  the  bondholder.  The  whole 
agreement  is  consummated  at  the  date  of  issue  and  the  market 
at  that  date  governs  the  whole  contract  regardless  of  how  long 


410  PRINCIPLES  OF  ACCOUNTING 

the  time  covered  by  the  contract  may  be.  There  can  be  no 
change  in  the  market  rate  of  interest  paid  by  the  corporation  so 
long  as  it  is  fulfilling  the  terms  of  the  original  contract.  Any 
change  in  the  general  market  situation  affecting  interest  rates 
cannot  affect  the  terms  of  this  contract.  Hence  so  long  as  the 
original  contract  remains  in  force,  that  is,  so  long  as  the  bonds  are 
outstanding,  the  original  market  rate  of  interest  controls  the 
journal  entries  as  they  have  already  been  shown. 

A  company  may  have  chosen  to  issue  its  bonds  at  an  inoppor- 
tune time,  and  thereby  be  compelled  to  pay  a  high  rate  of  interest. 
If  this  is  the  case,  that  rate  will  apply  to  all  of  that  corporation's 
transactions  relating  to  these  bonds  until  they  are  redeemed 
either  at  maturity  or  at  an  earlier  date.  This  is  undoubtedly 
the  reason  why  corporations  usually  issue  short-term  bonds, 
five-  and  ten-year,  during  a  period  when  the  interest  rate  is  high, 
and  long-term  bonds,  twenty-,  thirty-  or  fifty-year,  when  the  in- 
terest rate  is  very  low.  It  is  an  evidence  of  good  financial  man- 
agement to  choose  a  period  of  low  interest  rates  in  financing 
through  bond  issues. 

In  order  that  a  concern  might  avail  itself  of  an  opportunity  to 
get  the  benefit  of  an  improvement  in  the  interest  rate  in  its  favor, 
bonds  are  sometimes  issued  which  are  callable  at  certain  dates 
by  the  corporation  at  par,  or  slightly  above  par.  When  this  is 
the  case  the  corporation  has  the  right  to  cancel  the  old  contract 
by  paying  the  bondholder  the  par  value;  and  then  it  may  go 
on  the  market  with  an  entirely  new  issue  which  will  be  sold  at 
the  new  market  rate.  This  process  of  refunding  a  debt  for  the 
purpose  of  getting  a  better  rate  seldom  presents  any  very  compli- 
cated accounting  problems.  The  accounts  representing  the  old 
contract  at  the  date  of  refunding  must  be  written  off  the  books, 
and  the  new  bonds  entered  in  the  new  accounts. 

Sometimes  the  option  of  cancelling  the  contract  before  maturity 
rests  with  the  bondholder.  He  may,  on  certain  specified  dates, 
present  his  bond  for  redemption  either  at  par  or  at  some  other 
stated  price.  He  will  exercise  this  privilege  if  the  interest  rate 
is  increasing  in  order  to  make  a  more  profitable  investment, 
but  if  the  interest  rate  is  falling,  he  will  prefer  to  keep  the 
bond.  In  case  he  does  exercise  his  privilege,  the  old  accounts 
representing  the  bonds  involved  must  be  closed  out. 


INTEREST  TRANSACTIONS  —  EQUITY  ACCOUNTS      411 

Still  another  case  of  refunding  consists  in  the  issuing  of  a  new 
security  in  exchange  for  an  old  one.  A  second  mortgage,  5  per 
cent  bond  with  five  years  yet  to  run,  for  example,  might  be  can- 
celled in  exchange  for  a  4!  per  cent  first  mortgage  thirty-year 
bond.  If  the  exchange  is  made  at  par,  then  any  discount  or 
premium  still  on  the  books  from  the  old  issue  must  be  spread 
over  the  succeeding  thirty  years  instead  of  five.  This  case 
always  involves  the  finding  of  the  interest  rate  of  the  new  issue 
of  bonds  as  was  shown  in  Chapter  XVI.  If  the  exchange  is  not 
made  at  par,  the  case  is  much  more  complicated  but  it  would  be 
treated  the  same  in  principle  as  though  the  old  issue  were  can- 
celled through  payment,  and  the  new  securities  issued  in  exchange 
for  the  proceeds  of  the  old.  The  balances  in  the  discount  or 
premium  accounts  would  be  increased  or  decreased  according 
to  the  terms  of  exchange. 

There  are  so  many  different  situations  that  might  arise  in  con- 
nection with  the  refunding  of  securities  that  no  adequate  classi- 
fication can  be  made.  The  general  statement  can  be  made, 
however,  that  at  the  time  of  any  refunding,  accounts  represent- 
ing the  old  contract  should  be  closed  entirely  and  new  accounts 
opened  for  the  new  contract  in  accord  with  the  terms  of  the  issue. 
The  accounts  for  the  old  issue  should  have  been  kept  up  to  the 
date  of  refunding  according  to  the  principles  as  shown  in  the  pre- 
ceding sections,  and  the  new  issue  should  be  handled  according 
to  the  same  principles  from  that  date  forward.  The  main  prac- 
tical difficulty  which  usually  arises  is  the  finding  of  the  new 
interest  rate. 

It  has  been  the  purpose  of  this  chapter  to  explain  the  more 
important  transactions  involving  interest  calculations  from  the 
viewpoint  of  the  equity  accounts.  It  will  be  the  purpose  of  the 
next  chapter  to  consider  the  same  question  from  the  standpoint 
of  the  property  accounts. 


XVIII 

INTEREST  TRANSACTIONS  —  ASSET  ACCOUNTS 

THE  last  chapter  was  concerned  with  the  interest  transactions 
primarily  as  they  affect  the  equity  accounts.  It  is  obvious  that 
the  same  transactions  which  were  discussed  in  this  connection 
also  involve  the  asset  accounts  on  some  ledgers.  To  make  this 
clear  one  need  only  be  reminded  that  there  are  two  points  of  view 
to  every  list  of  asset  items ;  one  has  to  do  with  the  equities  in 
the  property,  the  other  with  the  property  items  themselves. 
Every  equity  item  on  one  balance  sheet  may  be  represented  on 
the  asset  side  of  the  balance  sheet  of  the  party  holding  title  to 
the  equity.  Capital  stock,  bonds,  notes,  etc.,  are  all  equities  on 
the  balance  sheet  of  the  corporation  which  has  issued  them,  but 
the  same  items  are  assets  on  the  books  of  the  owners  of  the  shares 
of  stock,  the  bonds,  the  notes,  etc.  Further,  certain  firms  and 
individuals  act  as  trustees,  executors,  administrators,  and  in 
other  fiduciary  relationships  to  persons  who  own  property  of 
this  character.  In  such  cases,  an  analysis  of  the  interest  trans- 
actions involved  is  of  particular  importance.  It  is  the  purpose 
of  this  chapter  to  raise  the  problem  of  interest  with  particular 
reference  to  the  asset  accounts. 

INVESTMENTS   IN   SECURITIES 

The  first  question  to  be  considered  in  this  connection  is  con- 
cerned with  the  investment  by  individuals  and  companies  in  the 
securities  of  other  concerns.  Whenever  a  firm  or  corporation 
invests  in  the  notes,  annuities,  or  bonds  of  another  corporation, 
these  securities  must  be  entered  in  asset  accounts  and  the  earn- 
ings must  be  credited  to  the  appropriate  net  revenue  accounts  for 
the  periods  during  which  the  revenue  is  earned.  At  first  thought 
one  might  suggest  that  the  entries  on  the  books  of  the  owner  of 

412 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS      413 

the  securities  should  be  the  reverse  of  those  on  the  books  of  the 
issuing  company.  This,  however,  need  not  always  be  the  case. 
The  reason  for  this  difference  requires  careful  consideration. 
To  make  the  question  concrete,  suppose  that  the  X  Company 
has  purchased  the  amount  of  $100,000.00  par  value  of  the  4  per 
cent,  twenty-year  bonds  of  the  Y  Company,  on  a  5  per  cent  basis, 
interest  convertible  semiannually,  the  principal  being  $87,448.62. 
Now  as  was  shown  in  the  last  chapter  the  entries  to  be  made  on 
the  books  of  the  Y  Company  would  be, 

Cash ,    .    .    .    .    $87,448.62 

Discount  on  Bonds 12,551.38 

Bonds $100,000.00 

At  the  date  of  the  first  interest  payment  the  interest  accrued 
would  be  2\  per  cent  of  $87,448.62,  and  the  entries, 

Interest $2,186.22 

Cash $2,000.00 

Discount  on  Bonds    ....  186.22 

would  be  made.  The  valuation  of  the  bonds  remains  on  the 
books  on  a  5  per  cent  basis,  and  will  remain  so  throughout  the 
whole  twenty  years,  or  at  least  until  the  bonds  are  refunded.  It 
was  shown  in  some  detail  that  this  must  be  the  basis  of  entry 
on  the  books  of  the  issuing  company,  and  that  no  change  in  the 
basis  of  valuation  should  be  made  as  long  as  the  original  contract 
remains  in  force.  The  transaction  takes  place  on  a  5  per  cent 
basis  and  no  act  of  the  corporation  (except  payment  of  the  bond, 
refunding  or  failure)  can  alter  this  condition.  The  Y  Company, 
therefore,  accumulates  discount  according  to  the  principles  out- 
lined. 

Now  the  question  at  this  point  is  whether  the  X  Company 
should  make  entries  exactly  the  reverse  of  those  for  the  Y  Com- 
pany. That  is,  should  the  entries  on  the  date  of  purchase  and 
at  the  first  interest  payment  date  respectively  be, 

d) 

Bonds  Owned $100,000.00 

Cash $87,448.62 

Discount  on  Bonds  Owned      .  12,551.38 


414  PRINCIPLES  OF  ACCOUNTING 

and, 

(2) 

Cash $2,000.00 

Discount  on  Bonds  Owned 186.22 

Interest $2,186.22 

According  to  this  policy  the  bonds  are  carried  on  the  books  as 
an  asset  at  all  times  at  a  net  valuation  determined  by  the  present 
values  of  the  future  sums  on  a  5  per  cent  basis.1 

It  would  seem  offhand  as  if  this  were  the  proper  procedure, 
since  this  is  just  the  other  side  of  the  same  contract  which  was 
recorded  on  the  Y  Company's  books'.  If  this  were  the  method 
always  to  be  adhered  to,  there  would  be  no  necessity  for  going 
further  into  an  analysis  of  the  entries  on  the  books  of  the  investor, 
since  in  every  case  of  the  purchase  of  a  security  the  purchaser 
would  make  exactly  the  reverse  entries  of  those  made  on  the  books 
of  the  issuing  company ;  and  these  entries  were  explained  in  the 
last  chapter.  But  there  is  some  reason  for  inquiring  as  to  a 
possible  difference  in  the  attitude  of  the  investor  toward  the 
investment,  as  compared  with  that  of  the  issuing  company. 
The  essential  difference  lies  in  the  fact  that  the  original  owner 
of  the  bond  need  not  remain  an  owner  until  the  contract  is  can- 
celled. The  corporation  issuing  the  bond  is  always  one  party 
to  the  contract  but  the  other  party  may  change,  in  fact  often 
does  change  because  of  the  very  ease  of  transferring  securities 
from  hand  to  hand.  An  investigation  of  the  purposes  for  which 
securities  are  purchased  will  show  that  changes  in  the  market 
rate  of  interest  must  in  many  cases  at  least  be  the  basis  for  read- 
justments on  the  books  of  the  purchaser  when  such  readjust- 
ments would  be  entirely  erroneous  on  the  books  of  the  issuing 
company. 

What  then  are  the  purposes  involved  in  the  purchase  of  such 
securities?  For  convenience  of  discussion  the  following  classi- 
fication maybe  of  service:2  (i)  investments  where  the  con- 

1  It  is  probably  unnecessary  at  this  point  to  explain  what  is  meant  by  the  net 
valuation.    The  bonds  are  carried  on  the  asset  side  at  par  in  the  Bonds  account ; 
Discount  on  Bonds  Owned  is  a  valuation  account  which  shows  the  offset  to  par ; 
and  the  net  valuation  of  the  securities  involved  is  the  algebraic  sum  of  the  balances 
from  these  two  accounts. 

2  This  classification  is  not  intended  to  be  exhaustive  but  rather  to  serve  as  a 
basis  of  investigation. 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS       415 

tractual  character  is  dominant;  (2)  long-term  investments 
which  may  be  easily  disposed  of ;  (3)  temporary  and  specula- 
tive investments. 

In  the  first  group  would  fall  the  annuities  purchased  from  life 
insurance  companies,  the  endowment  funds  of  institutions  and 
societies,  and  securities  for  which  there  is  little  or  no  market. 
In  any  of  these  cases  the  buyer  has  no  intention  of  selling  the 
security  before  maturity.  The  original  owner,  and  investor,  for 
practical  purposes,  may  be  looked  upon  as  the  other  party  to 
the  contract  permanently.  In  the  case  of  an  annuity  purchased 
from  a  life  insurance  company,  for  example,  there  is  very  little 
opportunity  to  dispose  of  the  security.  Of  course  the  owner 
might  make  an  assignment  of  his  right  to  receive  the  annuity 
installments  but  even  this  is  an  exceptional  case  and  as  such  would 
not  affect  the  generalization  with  respect  to  this  class  of  assets. 
Certainly  a  change  in  the  market  rate  of  interest  would  have  little 
or  no  effect  on  the  value  of  such  a  security  to  the  owner.  The 
investor  in  securities  of  this  class  looks  upon  his  investment  as 
the  other  side  of  a  contractual  agreement,  and  he  should  make 
entries  on  his  books  which  are  the  reverse  of  those  on  the  books 
of  the  issuing  company. 

The  statement  that  the  entries  in  all  cases  in  this  class  must 
always  be  the  reverse  of  those  on  the  books  of  the  issuing  com-  • 
pany  must  not  be  taken  as  a  rule  to  be  rigidly  adhered  to.  Con- 
ditions might  arise  which  would  cause  a  change  in  policy.  The 
risks  assumed  by  the  investor  might  be  considerably  increased 
due  to  the  fact  of  the  issuing  company  becoming  financially 
embarrassed.  If  such  new  conditions  bring  with  them  a  loss  to 
the  investor  such  loss  should  be  recognized  in  the  accounts. 
But  such  situations  are  not  typical  of  securities  alone.  Any  asset 
item  may  suddenly  become  worthless  because  of  some  unforeseen 
contingency,  and  in  such  cases  accounting  practice  demands  that 
the  book  value  of  the  asset  be  reduced.  The  exceptional  loss  of 
any  asset  must  be  recognized  by  a  charge  to  net  revenue  or  sur- 
plus at  the  time  it  is  incurred.  The  rule  given  for  the  treatment 
of  the  securities  in  this  class  may  therefore  be  accepted  with  this 
general  reservation. 

It  is  somewhat  difficult  to  delimit  this  class  of  investments. 
The  test  which  can  be  applied  with  best  success  is  the  question : 


41 6  PRINCIPLES  OF  ACCOUNTING 

does  the  investor  to  all  practical  intents  become  a  permanent 
owner  of  the  security  ?  If  this  question  can  be  answered  in  the 
affirmative,  the  whole  transaction  may  be  treated  as  a  contract 
governed  by  the  general  rule  for  this  class,  and  there  are  certainly 
several  situations  in  which  the  question  asked  may  be  answered 
affirmatively.  The  purchase  of  an  annuity,  already  mentioned, 
is  perhaps  the  clearest  case.  But,  again,  if  an  organization  such 
as  an  educational  institution  is  endowed,  the  fund  being  turned 
over  in  the  form  of  bonds  of  a  particular  corporation,  the  case 
is  practically  a  parallel  with  that  of  the  annuity.  The  insti- 
tution must,  from  the  nature  of  the  contract,  keep  the  secu- 
rities until  maturity. 

Another  case,  not  quite  so  clear  perhaps,  is  the  investment  in 
bonds  or  other  securities  of  small  corporations  or  municipalities 
for  which  there  is  practically  no  market.  When  an  individual 
or  firm  invests  in  such  securities  his  intention  generally  is  to 
retain  possession  until  maturity.  He  may  sell  before  that  date, 
but  unless  he  does,  he  has  no  basis  for  making  a  revaluation  as 
there  is  no  general  market  for  such  securities  which  can  be  ob- 
served by  the  investor.  He  must  therefore  accept  the  interest 
rate  involved  in  his  own  original  purchase  price  as  the  basis  for 
future  valuations  until  such  date  as  he  actually  disposes  of  his 
holdings.  Such  investments  form  no  inconsiderable  part  of  the 
total.  To  make  this  evident  one  need  only  recall  from  his  own 
observation  the  fact  that  the  securities  actively  dealt  in  and 
quoted  on  various  stock  exchanges  constitute  a  very  small  per- 
centage of  the  total  securities  in  the  hands  of  the  public.  There- 
fore it  may  be  assumed  that  the  number  of  cases  is  very  large  in 
which  asset  items  represented  by  securities  must  be  recorded  by 
entries  essentially  the  reverse  of  those  on  the  books  of  the  issuing 
company. 

The  second  class  consists  of  long  time  investments  for  specific 
purposes.  The  investments  of  insurance  companies  to  meet 
their  reserve  requirements,  of  trust  companies  for  savings  funds 
and  estates,  the  sinking  funds  of  corporations,  municipalities, 
and  the  like,  come  in  this  class.  Should  there  be  any  difference 
in  the  treatment  of  these  items  as  distinct  from  the  first  class? 
There  is  more  reason  for  making  adjustments  in  accordance  with 
changes  in  the  market  situation  here,  for  the  investment  is  not 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS      417 

made  with  the  intention  of  retaining  the  securities  until  maturity. 
The  individual  or  corporation  in  this  case  makes  the  investment 
for  the  purpose  of  earning  some  interest  on  funds  which  are  not 
needed  for  current  operations  but  which  must  be  available  to 
meet  its  own  future  demands.  An  insurance  company,  for 
example,  invests  in  bonds  of  another  corporation  in  order  to  earn 
some  interest  on  funds  that  are  awaiting  the  demands  of  its 
policy  holders.  The  important  consideration  for  the  insurance 
company  is  to  have  funds  always  available,  either  in  cash  or 
securities  which  can  readily  be  turned  into  cash,  to  meet  the 
maturity  claims  of  its  policy  holders.  Changes  in  the  market 
prices  of  the  securities  held  for  investment  purposes  therefore 
are  of  particular  importance  and  should  be  made  a  matter  of 
record.  The  same  thing  may  be  said  in  general  of  the  other  in- 
vestments in  this  group. 

Investments  made  in  securities  that  are  likely  to  be  resold 
should  therefore  be  kept  on  the  books  at  approximately 
the  current  price.  This  does  not  mean,  however,  that  every 
fluctuation  in  price  as  reported  on  the  stock  exchange  should 
be  recorded  on  the  books.  The  claims  to  be  met  by  these  secu- 
rities are  not  demand  claims  in  the  sense  that  the  funds  must  be 
available  immediately  on  presentation  of  a  claim.  There  is 
always  the  right  reserved  to  defer  the  payment  of  a  claim  for 
some  considerable  time,  sufficient  at  least  to  enable  the  company 
to  dispose  of  its  securities  at  an  advantageous  price.  Small 
fluctuations  in  the  quoted  price,  therefore,  are  of  little  signifi- 
cance. It  is  the  relatively  permanent  or  long  time  changes 
that  must  be  booked. 

As  an  example  of  the  change  in  price  referred  to,  suppose  that 
the  bonds  purchased  by  the  X  Company  in  the  illustration  on 
page  413  were  of  this  class.  That  is,  the  X  Company  made  the 
investment  with  the  intention  of  keeping  a  fund  available  to  meet 
certain  future  claims  upon  itself.  At  the  date  of  purchase  it  is 
supposed  of  course  that  the  bonds  would  retain  a  5  per  cent  val- 
uation basis  as  this  is  the  basis  on  which  the  bid  is  made.  The 
original  entries  then  are  the  same  as  shown  above,  namely, 

Bonds $100,000.00 

Cash $87,448.62 

Discount  on  Bonds  Owned      .  12,551.38 

2E 


4i8  PRINCIPLES  OF  ACCOUNTING 

An  accumulation  table  would  be  prepared  on  a  5  per  cent  basis 
for  the  purpose  of  making  the  entries  which  would  be  the  reverse 
of  those  on  the  Y  Company's  books,  and,  assuming  no  essen- 
tial changes  in  the  market  price  of  this  bond  the  entries  would 
be  made  on  this  basis.  At  the  first  interest  payment  date  this 
entry  would  be  made, 

Cash $2,000.00 

Discount  on  Bonds  Owned 186.22 

Interest $2,186.22 

And  at  each  subsequent  payment  date  the  entries  would  be  made 
on  the  same  basis  unless  some  change  in  the  market  price  of  im- 
portance took  place. 

Now  suppose,  however,  that  the  market  price  of  these  bonds 
had  changed  to  a  5!  per  cent  basis  by  the  first  interest  payment 
date.  The  value  of  the  bonds  to  the  X  Company  would  no  longer 
be  the  same  as  the  book  value  after  the  above  entries  were  made. 
The  value  would  be  $82,194.81.  But  the  book  value,  after  the 
interest  payment  is  received  and  the  journal  entry  recording  the 
receipt  has  been  made  on  the  5  per  cent  basis,  as  shown  in 
the  journal  entry  of  the  preceding  paragraph,  is  $87,634.84. 
The  new  book  value  should  then  be  $5,440.03  smaller  than 
that  shown  in  the  accumulation  table  at  5  per  cent.  To  make 
this  correction  the  entries  should  be, 

Net  Revenue $5,440.03 

Discount  on  Bonds  Owned  .     .  $5,440.03 

The  two  journal  entries  taken  together  show  a  net  loss  for  the 
period  of  $3,253.81 .  The  first  entry  credits  Interest  (net  revenue) 
with  $2,186.22  and  the  second  charges  Net  Revenue  with 
$5,440.03,  which  gives  the  net  result  as  stated.  The  credit  to 
Discount  on  Bonds  Owned  reduces  the  book  valuation  and 
leaves  the  net  valuation  at  $82,194.81.  This  is  the  present 
value  of  the  bond  (now  having  19^  years  to  run)  on  a  5!  per 
cent  basis.  A  new  accumulation  schedule  should  be  made  out 
and  the  entries  made  according  to  this  schedule  until  a  rather 
significant  change  occurs  in  the  market  rate. 

In  the  case  just  given,  the  market  rate  increased,  causing  a 
loss  to  the  investor.  Many  investment  concerns  which  approve 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS       419 

of  this  policy  in  this  case  nevertheless  object  to  writing  up  the 
asset  if  the  market  rate  of  interest  decreases.  Suppose,  for  ex- 
ample, that  the  market  rate  had  fallen  to  4!  per  cent  instead  of 
rising.  The  present  value  would  have  been  $93,554.28  and  a 
consistent  policy  would  require  the  writing  up  of  the  book  value 
as  follows, 

Cash $2,000.00 

Discount  on  Bonds  Owned 6,105.66 

Interest  (on  5%  basis)     ....  $2,186.22 

Net  Revenue  (for  appreciation)    .  5,919.44 

Subsequent  entries  should  be  based  on  an  accumulation  table  at 
4^  per  cent  until  some  further  change  in  the  interest  rate. 

The  objector  would  say  that  the  appreciation  of  the  assets, 
$5,919.44,  is  not  realizable  and  therefore  should  not  be  considered 
as  a  revenue  of  the  period.  This  is  just  the  old  question  as  to 
whether  appreciation  of  assets  in  general  should  be  recognized 
in  the  accounts;  and  as  has  been  shown  at  numerous  places, 
since  it  is  the  function  of  accounts  to  represent  as  far  as  possible 
present  values,  appreciation  is  logically  as  significant  a  fact  as 
depreciation.  The  question  as  to  whether  cash  has  been  re- 
ceived equal  to  the  credit  to  Net  Revenue  is  unimportant.  An 
asset  item  of  value  equal  to  cash  is  present  and  available. 

The  general  conclusion  with  respect  to  the  second  class  of 
securities,  therefore,  is  that  changes  in  the  rate  of  interest  of  a 
relatively  permanent  character  should  be  recognized  in  the  ac- 
counts. 

The  third  class  of  investments  in  securities  mentioned  above 
consists  in  funds  which  are  invested  very  temporarily  and  which 
must  be  available  for  other  purposes  practically  on  demand. 
The  purchase  of  stocks  and  bonds  by  brokers,  or  more  particularly 
the  acceptance  of  such  securities  by  banks  as  security  for  loans, 
are  the  typical  examples  of  such  investments.  There  is  perhaps 
some  question  as  to  the  advisability  of  considering  these  as  in- 
vestments, since  they  belong  more  in  the  category  of  speculative 
holdings.  . 

In  all  cases  of  this  class,  the  assets  must  be  highly  liquid  in 
character.  It  must  be  possible  to  dispose  of  them  readily  to 
avoid  financial  embarrassment.  In  fact  the  securities  are  often 


420  PRINCIPLES  OF  ACCOUNTING 

a  form  of  merchandise  for  the  firm  holding  them  and  ability  to 
meet  current  liabilities  depends  in  large  measure  on  the  oppor- 
tunity to  dispose  readily  of  the  stocks  and  bonds  held.  The 
market  situation  therefore  is  of  the  utmost  importance  and  ac- 
cumulation and  amortization  schedules  are  of  little  or  no  use. 
In  most  of  these  cases  there  is  an  active  market,  and  valuations 
on  the  books  should  be  adjusted  to  correspond  with  the  quoted 
market  prices  very  frequently.  A  broker,  for  example,  should 
recognize  market  changes  at  least  daily  and  in  many  cases  it  is 
better  to  follow  the  changes  throughout  the  open  market  hours 
of  the  day.  Banks  holding  large  amounts  of  securities  as  col- 
lateral keep  constantly  in  touch  with  the  stock  market,  being 
prepared  to  sell  the  collateral  to  cover  loans  in  case  prices  should 
materially  lower. 

It  is  evident  that  in  this  group,  the  mathematics  of  investment 
plays  no  part  in  the  revaluation  of  securities  owned.  The  con- 
tinued contract  relationship  with  the  issuing  company  is  not 
intended  nor  is  the  purchase  made  for  relatively  long-term  in- 
vestment purposes.  The  market  is  the  continual  basis  of  valua- 
tion. 

The  conclusions  reached  in  this  section  may  be  briefly  summa- 
rized as  follows.  There  are  roughly  three  classes  of  invest- 
ments in  securities.  The  first  consists  of  long-term  invest- 
ments of  which  the  investor  intends  to  retain  his  possession 
until  maturity.  Here  the  contractual  character  of  the  trans- 
action is  recognized  and  subsequent  valuations  should  be  made 
on  the  basis  of  the  original  market  rate  of  interest.  The  second 
consists  of  long-term  investments  made  primarily  for  investment 
purposes  where  there  is  no  intention  of  recognizing  the  continued 
contractual  relationship.  Here  small  changes  in  market  condi- 
tions should  not  be  recognized  but  relatively  permanent  changes 
should  be  the  basis  for  revised  book  figures.  The  third  class 
consists  of  speculative  investments.  Here  the  market  situation 
is  the  sole  guide  to  the  revision  of  book  valuations.  It  is  impos- 
sible to  give  a  hard  and  fast  rule  as  to  just  when  a  security  is  in 
one  or  the  other  of  these  classes  but  the  facts  of  each  situation 
should  be  taken  into  consideration  in  making  the  assignment. 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS      421 


INTEREST  IN   FIDUCIARY  ACCOUNTING 

Many  of  the  questions  already  raised  in  connection  with  prin- 
cipal and  interest  present  themselves  in  a  peculiar  manner  to 
the  person  or  corporation  acting  in  a  fiduciary  capacity.  The 
most  common  example  is  the  trusteeship  for  an  estate.  The 
trustee  is  intrusted  with  the  administration  of  the  estate  of  the 
deceased  in  accordance  with  the  terms  of  the  will.  In  general 
this  task  does  not  present  any  particular  problems  as  distinct 
from  any  other  form  of  accounting.  The  estate  must  be  admin- 
istered in  a  businesslike  manner  in  the  interests  of  the  beneficiaries. 
The  property  belonging  to  the  beneficiaries  is  managed  by  the 
trustee.  All  net  revenue  as  well  as  the  corpus  of  the  estate  is 
distributed  according  to  the  terms  of  the  probated  will. 

It  would  seem  proper  then  to  compare  the  position  of  the 
trustee  with  that  of  the  manager  of  a  private  business.  He 
manages  the  property  or  business  of  others  and  renders  periodic 
accounting  statements  to  those  who  have  equities.  The  essential 
difference  lies  in  the  apportionment  of  the  net  revenue  and  assets 
to  the  proper  parties.  Instead  of  a  board  of  directors  meeting 
to  decide  on  these  questions,  the  will  of  the  deceased,  as  approved 
by  the  proper  court,  is  the  guide.  The  actual  records  kept  and  the 
method  of  recording  transactions  are  highly  specialized,  but  the 
accounting  principles  are  essentially  the  same  as  for  any  business. 

The  importance  of  maintaining  the  integrity  of  the  account- 
ing period  in  this  case  should  be  especially  emphasized.  The 
will,  for  example,  often  specifies  that  the  income  of  the  estate 
shall  be  paid  to  one  person  (the  life  tenant),  throughout  his  or 
her  life  and  that  the  corpus  of  the  estate  shall  pass  to  another 
person  (the  remainder  man).  Now  it  is  evident  that  any  mis- 
statement  of  net  revenue  is  bound  to  jeopardize  the  interests 
of  either  one  or  the  other  of  these  parties.  To  make  the  case 
concrete  suppose  that  A  dies  and  leaves  an  estate  which,  after 
all  the  expenses  incident  to  probating  the  will,  taxes,  etc.,  have 
been  met,  amounts  to  $106,838. 87. 1  The  will  provides  that  all 

1  The  amount  was  assumed  at  this  figure  to  make  the  illustration  particularly 
effective.  In  no  case  would  the  whole  estate  happen  to  equal  the  present  value  of 
some  particular  bond  at  the  market  rate.  This  illustration  may  be  considered  to 
refer  to  the  part  of  such  an  estate  invested  in  a  particular  security. 


422  PRINCIPLES  OF  ACCOUNTING 

the  income  of  the  estate  should  go  to  the  widow  B,  and  that  at 
the  death  of  B  the  corpus  of  the  estate  should  pass  to  the  son  C. 
The  trustee  must  manage  the  investment  of  the  estate,  pay  ex- 
penses of  management,  obtain  his  own  fee  from  the  gross  revenue, 
and  pay  all  net  revenue  to  B  throughout  her  life.  Suppose  fur- 
ther that  the  trustee  decided  to  purchase  $100,000.00  par  value 
X  Company,  twenty-year,  4^  per  cent  bonds  which  are  quoted 
at  $106,838.87,  this  being  on  a  4  per  cent  basis.  The  balance 
sheet  of  the  estate  at  this  time  would  be, 

Bonds  —  X  Company  C's  Equity  .    .    $106,838.87 
Par     .     .     .     $100,000.00 

Premium     .          6,838.87  

$106,838.87  $106,838.87 

Now  at  the  end  of  six  months,  the  trustee  receives  $2,250.00 
from  the  X  Company  for  bond  interest.  How  should  this 
amount  be  treated  as  between  B  and  C  ?  It  is  clear  that,  unless 
the  market  rate  of  interest  has  fallen,  the  value  of  the  bonds  has 
decreased.  The  actual  interest  earned  is  $2,136.78,  and  there- 
fore the  remaining  $113.22  is  a  return  of  principal,  a  part  of  C's 
equity.  Only  $2,136.78  (ignoring  the  trustee's  commissions  and 
expenses)  should  be  turned  over  to  B,  and  the  balance  sheet  would 
then  show, 

Bonds  —  X  Company  C's  Equity    ....    $106,838.87 

Par      .     .    $100,000.00 

Premium .          6,725.65 

$106,725.65 
Cash 113.22 

$106,838.87  $106,838.87 

The  cash  item,  $113.22,  should  now  be  invested  as  a 
part  of  the  principal  and  the  interest  turned  over  to  B. 
At  the  next  interest  payment  date  only  2  per  cent  of 
$106,725.65  should  be  considered  as  income  (as  far  as  that 
portion  of  the  estate  invested  in  the  X  Company's  bonds  is 
concerned).  In  other  words  the  amortization  schedule  must 
be  used  to  apportion  the  bond  interest  payments  between 
the  two  beneficiaries.  It  should  be  the  purpose  of  the 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS      423 

trustee  to  keep  C's  equity  at  $106,838.87  continuously,  and 
this  could  be  accomplished  only  by  writing  off  the  bond 
premium,  as  shown  above.  Failure  to  recognize  the  necessity 
of  this  procedure  would  lead  to  the  dissipation  of  a  part  of 
the  estate.  That  this  would  be  the  case  may  be  shown 
very  clearly  by  assuming  that  B  lives  for  twenty  years  after  the 
death  of  A  and  that  the  bonds  of  the  X  Company  are  held  until 
maturity.  At  the  end  of  the  twentieth  year,  the  bonds  are  paid 
off  at  par  and  the  balance  sheet  would  then  show  only, 

Cash $100,000.00         C's  Equity      .     .     .    $100,000.00 

The  amount  of  $6,838.87  would  have  been  paid  to  B  in  the 
bond  interest  payments  at  the  expense  of  C's  equity.  If  the  total 
of  the  bond  interest  payments  were  treated  as  income,  then,  the 
terms  of  the  will  would  be  violated. 

On  the  other  hand,  the  trustee  might  have  purchased  bonds 
at  a  discount.  Here  the  accumulation  of  discount  table  should 
be  used.  In  order  to  simplify  the  illustration  in  this  case,  it 
will  be  assumed  that  the  estate  amounted  to  but  $93,724.30,  the 
conditions  of  the  will  being  as  before,  and  that  the  trustee  pur- 
chased $100,000.00  of  the  4!  per  cent,  twenty-year  bonds  of  the 
Y  Company  at  $93,724.30  —  this  being  on  a  5  per  cent  basis. 
The  balance  sheet  now  appears  as  follows, 

Bonds  —  Y  Company  C's  Equity  .     .     .      $93,724.30 

Par  ....    $100,000.00 
Less  Discount          6,275.70 

$93,724.30  $93,724.30 

Now  at  the  end  of  six  months  $2,250.00  is  received  from  the  Y 
Company  as  bond  interest  but  the  actual  interest  accrual  is 
$2,342.11;  and  this  amount  should  be  accounted  for  as  B's 
equity.  If  only  the  $2,250.00  were  turned  over  to  B  the  balance 
sheet  should  show, 

Bonds  —  Y  Company 

Par   ....    $100,000.00  C's  Equity .     .     .      $93,724.30 

Less  Discount .          6,182.59  B's  Equity .     .     .               93-n 

$93,817.41  $93,817.41 


424  PRINCIPLES  OF  ACCOUNTING 

The  value  of  the  investment  in  the  Y  Company's  bonds  has  in- 
creased by  $93.11,  and  since  income  goes  to  B  by  the  terms  of 
the  will,  this  must  be  considered  as  B's  equity. 

A  question  might  arise  as  to  how  this  income  can  be  paid  to  B 
inasmuch  as  there  is  no  cash  in  the  trustee's  hands  to  cover  this 
item.  This  is  a  very  practical  question.  B  might,  of  course, 
leave  the  income  with  the  trustee  on  deposit  so  to  speak  until 
the  bonds  mature.  The  obvious  objection  to  this  is  that  B 
might  die  long  before  this  time  and  would  have  been  deprived 
of  this  income  in  the  meantime.  C  might  purchase  the  right 
to  this  item  from  B  and  thus  have  it  credited  to  his  account ;  or 
in  some  cases  the  trustee  might  be  called  upon  to  make  the  ad- 
vance to  B,  accepting  a  lien  on  the  bonds  at  maturity  as  con- 
sideration. 

The  actual  decision  with  respect  to  the  treatment  of  B  in  this 
situation  is  not  an  accounting  matter.  Whatever  arrangement 
is  adopted  may  easily  be  recorded  in  the  books,  but  the  important 
accounting  consideration  is  the  recognition  of  the  accumulation 
of  discount  as  an  income  which  accrues  in  favor  of  the  life  tenant. 

Another  situation  might  arise  with  respect  to  the  bonds  either 
in  the  case  of  purchase  at  a  premium  or  at  a  discount.  The 
market  value  of  the  security  might  change.  It  might  show  a 
tendency  to  increase  permanently  or  decrease  permanently  in 
value.  Should  this  fact  be  considered  by  the  trustee?  This 
situation  would  come  under  the  second  class  of  cases  in  the 
preceding  section.  Permanent  changes  should  be  recognized. 
Failure  to  take  the  new  market  conditions  into  account  would 
work  to  the  disadvantage  of  the  remainder  man  in  case  of  falling 
prices  and  to  the  disadvantage  of  the  life  tenant  in  case  of  rising 
prices. 

In  the  discussion  thus  far  in  this  section  it  has  been  assumed 
that  the  trustee  simply  acts  as  agent  for  the  estate,  that  title  to 
the  property  remains  in  the  estate,  and  that  the  trustee  receives 
a  stipulated  fee  for  his  service.  In  many  cases,  however,  the 
trustee  takes  over  title  to  the  property  of  the  estate  and  agrees 
to  pay  a  definite  return  to  the  life  tenant  and  to  turn  over  funds 
equal  to  the  value  of  the  corpus  of  the  estate  to  the  remainder 
man  at  the  death  of  the  life  tenant.  In  such  cases  the  trustee's 
balance  sheet  shows  on  the  asset  side  the  property  to  which  he 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS      425 

has  title  and  on  the  liability  side  the  equity  of  the  remainder  man 
in  the  trustee's  assets.  Any  excess  of  assets  over  the  remainder 
man's  equity  (and  other  liabilities)  is  the  trustee's  own  equity. 
The  net  revenue  sheet  shows  a  distribution  of  income  to  the  life 
tenant  on  a  contractual  basis  and  any  residue  after  this  distribu- 
tion is  a  credit  to  the  trustee's  accounts.  No  particular  account- 
ing problems  as  distinct  from  those  in  the  preceding  section  arise 
here.  The  business  of  a  trustee  may  in  this  case  be  likened  to 
a  pure  investment  business,  and  the  estate  treated  as  a  long  time 
deposit  the  interest  on  which  is  paid  to  a  different  party  than  the 
investor. 

Other  cases  of  fiduciary  accounting,  while  often  involving  many 
complicated  questions,  do  not  as  a  rule  present  different  situations 
with  respect  to  interest  computations  and  analysis  than  those 
given.  A  special  discussion  of  accounts  for  receivers,  in  cases 
of  bankruptcy,  realization  and  liquidation,  etc.,  is  given  in  a  later 
chapter  of  the  text. 

SINKING  FUNDS 

It  is  customary  for  corporations  to  protect  the  interests  of  their 
bondholders  by  making  some  provision  in  the  bond  contract 
with  regard  to  assets  to  be  used  for  meeting  the  bonds  at  maturity. 
Often  this  provision  takes  the  form  of  a  sinking  fund  requirement. 
This  calls  for  the  setting  aside  of  a  special  fund  to  accumulate 
by  the  annual  contributions  of  the  corporation,  and  interest 
earned  on  the  fund,  to  the  par  of  the  bonds  at  maturity.  The 
funds  thus  set  aside  may  be  placed  in  the  hands  of  a  trustee  out- 
side of  the  organization,  or  may  be  retained  as  a  separate  fund 
in  the  possession  of  the  corporation  but  not  used  for  current  opera- 
tions. The  accounting  entries  for  sinking  funds  are  of  particular 
interest  as  considerable  confusion  exists  on  this  point. 

The  amount  of  the  sinking  fund  contribution  may  be  deter- 
mined by  formula  (25).  The  rate  of  interest  involved  may  be 
obtained  in  different  ways.  If  the  corporation  intends  to  handle 
the  fund  itself,  the  rate  of  interest  will  depend  on  what  can  be 
obtained  from  time  deposits  at  a  bank  or  trust  company,  or  on 
the  rate  it  can  expect  to  obtain  from  investment  in  other  secur- 
ities. If  the  fund  is  to  be  handled  entirely  by  a  trust  company, 
the  rate  may  be  determined  by  agreement.  The  trust  company 


426  PRINCIPLES  OF  ACCOUNTING 

agrees  to  pay  a  certain  rate,  say  4  per  cent,  on  all  contributions. 
Once  the  rate  has  been  decided  upon  the  annual  contribution 
necessary  may  easily  be  determined. 

For  an  illustration  of  the  entries  suppose  that  the  X  Company 
has  issued  $1,000,000.00  of  4  per  cent,  twenty-year  bonds,  with 
a  sinking  fund  proviso  in  the  bond  contract.  The  trust  company 
which  agrees  to  handle  the  fund  will  pay  4  per  cent  per  annum 
on  the  contributions.  The  annual  payment  necessary  then  is 
$33,581.75.  At  the  end  of  the  first  year  this  amount  is  paid  over 
to  the  trustee,  the  entries  being, 

Sinking  Fund  Assets      ......     $33,581.75 

Cash $33,581.75 

Of  course  the  debit  might  be  made  to  the  sinking  fund  trustee 
account,  but  for  balance  sheet  purposes  the  title  Sinking  Fund 
Assets  is  more  desirable.  At  the  end  of  each  successive  year, 
the  same  amount  would  be  paid  to  the  trust  company  and 
the  same  entry  made  until  the  end  of  the  twentieth  year,  when 
the  fund  would  have  accumulated  in  the  trustee's  hands  to 
$1,000,000.00. 

The  interest  as  it  accrues  in  the  hands  of  the  trustee  must  also 
be  recognized  on  the  corporation's  books.  At  the  end  of  the 
second  year  the  interest  amounts  to  $1,343.27.  This  is  retained 
by  the  trustee  but  it  is  property  of  the  corporation  and  should  be 
treated  as  such.  The  entries  would  be, 

Sinking  Fund  Assets $1,343.27 

Interest $1,343.27 

The  third  year's  interest  earning  on  the  fund  would  be  4  per  cent 
of  the  total  fund  at  the  beginning  of  the  third  year.  This  would 
be  $2,740.27,  and  the  entry  would  be  the  same  in  form  as  the 
previous  one. 

It  is  important  to  notice  the  effect  of  this  sinking  fund  policy 
on  the  balance  sheet  of  the  corporation.  Suppose,  for  example, 
that  the  X  Company  originally  issued  $1,000,000.00  of  stock  at 
par  together  with  the  same  amount  of  bonds  at  par  and  used  the 
proceeds  for  purchasing  the  necessary  fixed  and  current  assets 
for  carrying  on  its  operations.  The  balance  sheet  in  summarized 
form  would  show, 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS       427 

Property    (used    in  Capital  Stock      .     .    $1,000,000.00 

operation)  .     .     .    $2,000,000.00       Bonds 1,000,000.00 

$2,000,000.00  $2,000,000.00 

Now  at  the  end  of  the  first  year  let  it  be  assumed  that  all  pro- 
prietary net  revenue  is  distributed  to  the  stockholders  in  divi- 
dends so  that  there  will  be  no  accumulated  surplus.  Then  as  a 
result  of  the  sinking  fund  transactions  described  above,  $33,- 
581.75  of  the  original  property  used  for  business  operations  must 
have  been  converted  into  cash  and  the  cash  turned  over  to  the 
sinking  fund  trustee.  The  balance  sheet  would  then  show, 

Property    (used    in  Capital  Stock      .     .    $1,000,000.00 

operation)        .     .     $1,966,418.25      Bonds 1,000,000.00 

Sinking  Fund  Assets  33,581.75 

$2,000,000.00  $2,000,000.00 

Passing  now  to  the  end  of  the  second  year  and  making  the  same 
assumption  the  balance  sheet  would  show  that  additional  assets 
were  turned  over  to  the  sinking  fund  trustee  equal  to  the  second 
payment  and  interest  on  the  first.  Interest  on  the  first  payment, 
it  must  be  remembered,  was  credited  to  net  revenue  and  ac- 
cording to  the  assumptions  made  proprietary  net  revenue  is  paid 
in  dividends. 

Property    (used    in  Capital  Stock .     .     .    $1,000,000.00 

operation)        .     .    $1,931,493.23      Bonds 1,000,000.00 

Sinking  Fund  Assets  68,506.77  

$2,000,000.00  $2,000,000.00 


If  this  policy  were  continued  until  the  end  of  the  twentieth 
year  the  assets  would  consist  of  $1,000,000.00  used  in  business 
operations  and  $1,000,000.00  in  the  sinking  fund  trustee's  hands. 
The  latter  sum  of  course  would  then  be  used  for  paying  off  the 
bonds  and  there  would  be  left  but  $1,000,000.00  of  property 
represented  by  the  stockholders'  equity. 

It  must  be  admitted  that  this  is  an  extreme  case  but  it  was 
stated  in  this  form  to  illustrate  the  effect  of  the  sinking  fund 
policy  on  the  business  when  no  restrictions  are  placed  on  the 
payment  of  dividends.  The  effect  is  evident ;  the  bondholders' 


428  PRINCIPLES  OF  ACCOUNTING 

investment  is  gradually  transformed  from  property  used  in  the 
particular  business  for  the  purpose  of  producing  revenue,  to  a 
fund  in  the  hands  of  a  trustee.  The  margin  of  safety  for  the 
bondholder  is  not  altered  from  the  original  condition. 

This  is  an  unusual  case  as  the  average  corporation  would  not 
pay  all  of  its  net  revenue  in  dividends  but  would  accumulate  a 
surplus  of  some  size.  The  growth  of  that  surplus  is  of  particular 
importance  to  the  bondholders  as  the  margin  of  safety  for  the 
bond  increases  in  direct  proportion  to  the  increase  in  that  figure. 
The  bondholders  may  and  often  do  wish  to  have  that  surplus 
increase  by  exactly  the  same  amount  as  the  sinking  fund  in- 
creases each  year.  When  this  requirement  is  placed  in  the  bond 
contract  it  is  said  that  the  corporation  must  accumulate  its 
sinking  fund  "out  of  profits."  It  is  the  use  of  this  phrase  that 
causes  so  much  confusion  in  accounting  for  sinking  funds.  This 
phrase  simply  calls  upon  the  directors  to  set  aside  sufficient  net 
revenue  to  equal  the  sinking  fund  requirements  before  paying 
dividends,  and  further  to  label  that  part  of  the  surplus  so  re- 
served as  Sinking  Fund  Reserve.  This  part  of  the  requirement 
is  entirely  distinct  from  the  other  and  necessitates  another  pair  of 
journal  entries  each  year.  The  entries  the  first  year  would  be, 

Net  Revenue f33>58i.75 

Sinking  Fund  Reserve      .     .    .  $33>58i.75 

This  would  set  up  a  specialized  surplus  account  on  the  liability 
side  of  the  balance  sheet.  The  next  year  the  same  entries  would 
be  made  except  that  this  time  the  amount  should  be  increased  by 
the  amount  of  the  interest  accrual.  When  this  requirement  is  in- 
cluded in  the  contract,  the  property  used  in  business  operation 
can  be  maintained  at  $2,000,000.00  as  the  amount  turned  over 
to  the  trustee  comes  from  net  revenue  obtained  from  the  sale  of 
the  product. 

At  the  end  of  the  twentieth  year  the  sinking  fund  assets  would 
be  used  to  pay  off  the  bonds  and  the  balance  sheet  would  then 
appear, 

Property   (used     in  Capital  Stock       .     .    $1,000,000.00 

operation)  .     .     .    $2,000,000.00      Sinking  Fund  Reserve     1,000,000.00 

$2,000,000.00  $2,000,000.00 


INTEREST  TRANSACTIONS  —  ASSETS  ACCOUNTS      429 

The  Sinking  Fund  Reserve  then  becomes  a  free  surplus  as  was 
explained  in  a  previous  chapter.     (See  Chapter  XIII.) 

It  has  been  the  purpose  of  the  past  four  chapters  to  explain 
the  nature  of  the  interest  problem  as  it  affects  accounting  in 
general,  to  explain  certain  mathematical  formulae  for  the  com- 
putation of  interest,  to  illustrate  some  of  the  situations  that  arise 
which  require  interest  calculations  and  entries  in  connection 
with  equity  accounts,  and  to  analyze  similar  transactions  with 
respect  to  asset  accounts.  The  preceding  chapter  was  con- 
cerned with  problems  connected  with  the  equity  accounts  and 
therefore  with  the  subject  matter  of  Part  Two.  This  chapter 
is  concerned  primarily  with  the  valuation  of  certain  kinds  of 
assets  involving  interest  calculations  and  is  therefore  closely 
connected  with  the  subject  matter  of  Part  Four. 


PART   FOUR 
THE  VALUATION  OF  ASSETS 


XIX 

ORGANIZATION  AND  CONSTRUCTION 

UNDER  the  general  head  of  the  valuation  of  assets  it  will  be 
convenient  to  consider  first  the  problem  of  determining  the 
original  property  values  arising  during  the  organization  and 
construction  period.  The  setting  up  of  the  asset  accounts  and 
the  preparation  of  the  first  balance  sheet  are  matters  which 
often  involve  troublesome  questions.  This  is  particularly  true 
of  the  initiation  of  the  large  enterprise.  In  fact  the  extent  of 
the  financial  program  required  to  successfully  launch  the  typical 
modern  enterprise,  and  the  complex  nature  of  the  property  equip- 
ment necessary  to  the  operation  of  such  an  undertaking,  give 
rise  to  some  of  the  most  difficult  problems  of  accounting  analysis. 
The  organization  of  a  single-proprietor  enterprise  or  partnership, 
with  a  capital  outlay  of  a  few  thousand  dollars,  can  be  speedily 
accomplished,  and  the  purchase  or  actual  construction  of  the 
necessary  property  will  usually  require  but  a  few  weeks  —  or 
possibly  months.  The  modern  corporation,  however,  often  re- 
quires many  millions  in  capital,  and  the  construction  of  the 
property  —  in  the  case  of  a  railroad  enterprise,  for  example  — 
sometimes  covers  a  period  of  several  years.  In  the  following 
discussion  it  will  not  be  attempted  to  cover  completely  all  the 
accounting  problems  that  arise  in  this  connection.  But  suffi- 
cient illustrations  will  be  presented  to  suggest  the  nature  and 
scope  of  the  questions  involved,  and  as  far  as  possible  the  prin- 
ciples according  to  which  these  questions  must  be  answered  will 
be  stated. 

ORGANIZATION   COSTS 

It  is  sometimes  urged  that  certain  organization  costs  which  do 
not  directly  result  in  physical  property  should  be  considered  as 
expense  rather  than  as  investment.  Examples  of  such  items  are 

2F  433 


434  PRINCIPLES  OF  ACCOUNTING 

lawyers'  fees  and  other  clerical  incorporation  costs,  commissions 
paid  to  underwriters,  fees  paid  to  promoters,  etc.  There  is  no 
force  in  this  contention.  All  legitimate  costs  which  must  be 
incurred  to  bring  about  the  successful  organization  of  the  enter- 
prise can  properly  be  considered  as  cost  of  property  or  investment. 

In  the  first  place  it  should  be  observed  again  that  whether  an 
item  results  in  an  addition  to  physical  property  or  not  is  a  point 
of  little  significance  for  accounting.  Even  the  outlays  for  actual 
construction  represent  payments  for  elements  other  than  physical 
commodities.  Both  labor  and  material  costs  are  involved  in 
nearly  all  items  of  physical  property ;  and  material  cost  itself, 
moreover,  can  be  resolved  again  into  labor  and  material  cost. 
Both  commodities  and  services  are  purchased  concurrently 
during  the  entire  construction  period ;  and  one  cost  is  just  as 
thoroughly  a  part  of  the  investment  as  the  other.  The  property 
category,  as  has  been  emphasized  repeatedly  in  the  preceding 
pages,  is  fundamentally  an  economic  rather  than  a  physical  con- 
cept. 

Further,  the  engineering  costs  —  both  commodities  and  serv- 
ices —  are  no  more  properly  capital  outlays  than  are  the  costs 
of  financiering.  The  building  of  a  railroad,  for  example,  could 
never  be  accomplished  by  the  construction  engineer  alone.  The 
capital  of  the  investor  must  be  drawn  to  the  task,  and  it  may  be 
necessary  to  interest  hundreds  or  even  thousands  of  individual 
capitalists.  Hence  the  cost  of  the  promoters'  services  (the 
promoter  may  be  said  to  be  the  financial  engineer),  the  cost  of 
the  prospectus,  the  expenses  of  underwriting,  issuing  security 
certificates,  etc.,  fees  paid  to  the  government  for  the  privilege 
of  incorporation  —  all  these  outlays  are  property  charges. 

It  might  be  urged  that  some  services,  like  those  furnished  by 
the  underwriter,  do  not  have  definite  market  prices,  and  hence 
that  expenditures  for  such  services  are  susceptible  of  financial 
juggling  and  manipulation.  It  is  true  that  the  commissions  paid 
to  organizers  are  frequently  illegitimate  in  the  sense  that  nothing 
of  value  is  received,  and  occasionally  the  promoter  is  overpaid 
although  his  service  may  be  a  real  one;  but  there  is  nearly  as 
much  danger  of  the  exploitation  of  the  investor  through  unreason- 
able engineering  expenditures  as  through  the  costs  of  financier- 
ing. The  contractor's  "rake-off"  is  a  too-familiar  fact. 


ORGANIZATION  AND*  CONSTRUCTION  435 

In  determining  the  proper  property  charges  during  the  con- 
struction period  each  item  should  be  scrutinized  on  this  basis : 
does  the  charge  in  question  represent  a  condition,  service,  or 
commodity  necessary  to  the  initiation  of  the  enterprise,  and  was 
the  price  paid  a  legitimate  one  under  all  the  circumstances  ?  In 
the  case  of  complex  properties  it  is  probably  seldom  possible  to 
secure  a  record  in  the  property  accounts  which  represents  the 
status  of  the  assets  with  perfect  accuracy  at  the  moment  opera- 
tion begins.  The  complexities  and  accidents  of  the  individual 
case  as  well  as  the  errors  in  judgment  which  are  likely  to  occur 
on  the  part  of  those  immediately  concerned  preclude  the  pos- 
sibility of  such  a  result.  Some  of  these  difficulties  will  be  con- 
sidered in  the  following  sections.  But  certainly  the  test  as  to 
whether  or  not  a  particular  cost  is  directly  connected  with  a 
tangible  result  is  no  satisfactory  criterion  as  to  the  legitimacy 
of  considering  the  cost  in  question  a  capital  charge. 

Some  question  arises  as  to  what  particular  property  accounts 
should  be  charged  with  organization  costs  which  do  not  result 
directly  in  tangible  property.  How  should  costs  which  are  as- 
signable to  the  property  as  a  whole,  but  not  to  definite  units,  be 
treated  in  the  accounts?  It  would  be  possible  to  charge  these 
items  on  some  uniform  basis  to  the  specific  accounts  which  repre- 
sent tangible  property ;  and  the  rate  of  depreciation  on  the  tan- 
gible assets  could  be  altered  to  make  allowance  for  these  amounts. 
On  the  other  hand  such  costs  can  be  charged  to  special  accounts 
set  up  for  this  purpose  and  this  is  usually  much  the  best  pro- 
cedure. Wherever  costs  can  not  be  allocated  definitely  to  specific 
units  of  tangible  property,  and  hence  to  the  accounts  represent- 
ing these  units,  not  only  should  such  items  be  segregated  in  special 
accounts  but  the  amount  of  such  costs  should  appear  in  the 
balance  sheet  specifically  labeled.  If  this  practice  is  followed  a 
question  is  at  once  raised  as  to  the  legitimacy  of  any  item  which 
seems  disproportionately  large.  Unfortunately  it  is  common 
practice  to  charge  the  various  plant  and  equipment  accounts 
with  these  general  costs.  The  temptation  to  do  this  is  strong 
because  of  the  general  prejudice  in  favor  of  definite  tangible 
assets ;  but  such  a  practice  makes  it  possible  to  cover  up  unrea- 
sonable allowances  to  promoters,  construction  company  profits, 
and  actual  losses  under  the  head  of  tangible  property.  The 


436  PRINCIPLES  *OF  ACCOUNTING 

amount  of  organization  and  construction  costs  which  is  not 
definitely  assignable  to  specific  property  accounts  on  a  rational 
basis  should  therefore  always  be  set  up  in  a  separate  account. 
Even  if  the  property  is  a  simple  one  consisting  essentially  in  a 
single  important  asset  such  as  a  store  building  it  might  be  de- 
sirable to  distinguish  in  the  asset  accounts  between  general  ex- 
penditures and  ordinary  construction  costs. 

The  classifications  of  the  Interstate  Commerce  Commission 
prescribed  for  the  steam  railways  recognize  the  need  for  such 
special  organization  and  construction  accounts.  In  the  classi- 
fication "investment  in  road  and  equipment"  under  the  head 
"general  expenditures"  are  found  such  accounts  as  "Organiza- 
tion Expenses,"  "General  Officers  and  Clerks,"  "Law"  and 
"Stationery  and  Printing."  These  accounts  are  charged  with 
outlays  which  are  not  specifically  applicable  to  the  ordinary  asset 
accounts. 

DEPRECIATION   DURING   CONSTRUCTION 

The  treatment  of  depreciation  during  construction  constitutes 
another  important  problem  of  accounting  analysis.  Whenever 
the  construction  period  is  of  considerable  length,  physical  de- 
terioration of  property  inevitably  takes  place.  The  question 
arises  as  to  whether  this  deterioration  is  to  be  considered  as  giving 
rise  to  the  expiration  of  property  value  —  depreciation,  and 
whether  this  fact  should  be  shown  by  charges  to  expense  and  de- 
ductions from  the  cost  of  property.  If  one  is  to  be  consistent  with 
the  view  above  stated  that  all  outlays  for  commodities  and  serv- 
ices necessary  to  bring  about  the  initiation  of  the  enterprise 
are  costs  of  property  and  hence  investment,  then  a  negative 
answer  to  the  above  questions  must  be  given.  One  or  two 
analogies  may  serve  to  justify  this  conclusion.  In  constructing 
buildings  and  other  structures  much  material  is  consumed  which 
is  not  embodied  in  the  final  physical  result.  Consider,  for  ex- 
ample, the  "forms"  necessary  in  concrete  work.  This  material 
may  be  later  taken  down  and  discarded,  but  its  cost  is  always 
considered  as  part  of  the  cost  of  the  finished  structure.  Again, 
in  working  up  the  building  material,  the  workmen  are  obliged  to 
waste  a  considerable  amount.  Raw  materials  are  not  of  proper 
size  and  shape  and  some  waste  is  unavoidable.  Further,  the 


ORGANIZATION  AND   CONSTRUCTION  437 

costs  of  the  tools  and  machines  that  are  depreciated  or  worn  out 
in  construction  work  are  considered  as  a  part  of  the  cost  of  the 
property.  No  one  questions  any  of  these  cases.  Then  why 
should  the  wear  and  tear  of  the  permanent  parts  of  the  structure 
during  the  construction  period  be  deducted  from  the  cost  of  the 
property  and  considered  as  an  expense?  The  partial  decay  of 
physical  property  which  is  embodied  in  the  finished  structure 
is  one  of  the  costs  of  construction  akin  to  the  decay  of  property 
necessary  to  the  result  but  not  represented  in  the  physical  con- 
stitution of  that  result. 

Accordingly,  during  the  construction  period  proper  it  is  pos- 
sible for  a  property  as  a  whole  to  deteriorate  but  not  to  depreciate. 
At  the  end  of  the  construction  period  a  property  should  always 
stand  at  one  hundred  per  cent  of  its  legitimate  cost  (ignoring 
price  changes),  although  its  physical  efficiency  may  be  fifteen 
or  twenty  per  cent  less.  For  if  a  property  is  of  such  a  character 
that  its  condition  when  complete  is  inevitably  but  eighty  per  cent 
of  new  from  the  engineering  standpoint,  then  a  condition  of 
eighty  per  cent  physical  efficiency  must  represent  a  value  of  one 
hundred  per  cent. 

A  complication  arises  in  the  case  of  a  property  which,  when 
complete,  is  composed  of  a  number  of  distinct  units.  Take  the 
case  of  a  railroad  enterprise,  for  example,  which  requires  several 
years  for  organization  and  property  construction.  The  com- 
pleted property  will  be  composed  of  tracks,  bridges,  buildings, 
locomotives,  etc.  Each  class  of  property  —  or  even  each  im- 
portant asset  item  —  may  require  a  distinct  account.  Now  sup- 
pose, for  example,  that  twenty  locomotives  were  purchased  to 
haul  construction  trains,  and  that  at  the  end  of  the  construction 
period  these  locomotives  have  remaining  but  sixty  per  cent  of 
their  service  life.  At  the  time  of  purchase  the  cost  of  these  loco- 
motives was  recorded  in  a  distinct  account.  Then,  although  the 
property  as  a  whole  is  at  a  one  hundred  per  cent  value,  these 
particular  locomotives  have  actually  depreciated  forty  per  cent 
(ignoring  scrap  value),  and  if  the  account  recording  the  value 
of  these  locomotives  is  to  show  the  correct  status  of  these  specific 
property  items  it  will  be  necessary  to  credit  the  Locomotives 
account  with  this  item  of  depreciation.  In  what  account  should 
the  concurrent  charge  be  entered?  As  was  explained  above 


438  PRINCIPLES  OF  ACCOUNTING 

this  item  of  depreciation  does  not  constitute  a  property  expiration 
from  the  standpoint  of  the  property  as  a  whole.  The  locomotives 
in  question  have  virtually  given  up  their  value  in  constructing 
the  finished  property  in  the  same  manner  as  have  the  spades 
and  other  small  tools  used  for  grading.  Hence,  when  a  specific 
property  account  (or  a  valuation  account)  is  credited  to  indicate 
depreciation  during  construction  the  concurrent  debit  should 
be  to  some  other  property  account  and  not  to  expense.  But  in 
what  property  account  is  this  debit  item  incident,  supposing 
there  be  no  general  property  account? 

This  situation  calls  for  a  special  asset  account,  which  might 
properly  be  called  Depreciation  during  Construction.  This 
account  should  be  charged  with  all  the  credits  to  specific  property 
accounts  which  represent  depreciation  during  the  construction 
period.  In  this  way  the  status  of  individual  property  items  can 
be  accurately  reflected  in  the  accounts.  If  the  locomotives 
mentioned  above  depreciated  during  a  year  of  the  construction 
period  to  the  amount  Of  $30,000,  the  following  entries  would  be 
necessary  at  the  end  of  the  year : 

Depreciation  during  Construction  ....     $30,000 

Locomotives $30,000 

This  depreciation  account  represents  a  real  property  item  and 
should  be  maintained  as  a  permanent  asset  account  as  long  as 
the  property  as  a  whole  (investment)  remains  intact.  If  the 
other  capital  assets  become  depleted  the  amount  appearing  in 
this  account  should,  of  course,  be  written  down.  Such  an  ac- 
count represents  a  part  of  the  amount  by  which  the  value  of  the 
entire  property  as  a  completed  unit  exceeds  the  sum  of  the  values 
of  its  specific  parts  when  taken  individually. 

Any  construction  cost  which  cannot  be  directly  allocated  to 
specific  asset  accounts  gives  rise  to  the  need  for  a  special  asset 
account. 

INTEREST,    DIVIDEND   AND   TAX   ACCRUALS 
DURING  CONSTRUCTION 

It  was  emphasized  in  a  preceding  chapter  that  interest  in  some 
form  is  involved  in  all  transactions  covering  a  significant  period 
of  time.  Evidently,  then,  interest  on  the  capital  invested  ac- 


ORGANIZATION  AND   CONSTRUCTION  439 

crues  as  an  economic  fact  during  the  organization  and  construc- 
tion period.  This  can  perhaps  be  made  clear  by  an  illustration. 
Suppose  that  A  and  B,  equal  partners,  invest  $100,000  in  a  busi- 
ness enterprise.  It  requires  a  year  to  construct  the  plant,  in- 
stall the  equipment,  and  make  the  other  necessary  preparations 
for  operation.  During  this  time  no  sales  are  made  and  no  in- 
come is  realized,  yet  undoubtedly  the  finished  plant,  ready  to 
operate,  is  worth  more  than  $100,000.  It  has  a  value  of  $100,000 
plus  interest  on  $100,000  for  one  year  (assuming  that  it  was 
necessary  to  place  the  entire  amount  in  a  non-interest  bearing 
account  at  the  beginning  of  the  year) .  If  the  partners  were  now 
to  sell  the  completed  property  they  would  certainly  expect  to 
receive  something  more  than  $100,000 ;  and  normally  the  buyer 
would  expect  to  give  more  than  this  figure.  The  partners  have 
borne  the  burdens  of  risk  and  waiting  for  which  they  expected 
to  be  recompensed  in  later  prosperous  years.  If  they  bear  these 
burdens  and  forego  the  future  prospects  of  the  business  they  can 
reasonably  expect  some  remuneration. 

The  rate  of  interest  that  would  be  involved  in  such  a  sale, 
however,  would  be  somewhat  difficult  to  determine  in  advance. 
If  A  and  B  had  not  made  this  investment  they  might  have  al- 
lowed their  funds  to  remain  as  bank  deposits  drawing  perhaps 
four  per  cent.  As  another  possibility  they  might  have  invested 
in  securities  yielding  seven  per  cent.  Or  it  might  have  been  pos- 
sible for  the  partners  to  have  left  their  capital  in  some  com- 
mercial undertaking  where  it  would  have  yielded  fifteen  per  cent. 
On  the  other  hand  the  buyer  has  had  an  opportunity  during  the 
past  year  to  employ  his  capital  in  many  alternative  lines.  Prob- 
ably no  one  of  these  special  rates  would  be  effective  in  setting  the 
value  of  the  finished  plant.  The  market  rate  of  interest  implicit 
in  the  competitive  price  for  completed  establishments  of  the 
special  type  involved  would  be  the  effective  rate.  If  it  cannot  be 
said  that  there  is  any  regular  market  for  such  properties,  then  the 
rate  of  interest  would  be  determined  by  the  higgling  between 
buyer  and  seller  and  the  special  circumstances  involved  in  the 
transaction. 

If  A  and  B  do  not  sell  the  finished  plant,  however,  should  the 
year's  interest  accrual  be  recognized  on  their  books?  The  first 
practical  difficulty  arising  would  be  the  determination  of  the 


440  PRINCIPLES  OF  ACCOUNTING 

proper  rate  to  be  applied  to  the  investment  as  explained  above. 
Even  if  this  difficulty  be  ignored  other  more  serious  questions 
rise.  In  discussing  this  query  it  will  be  convenient  first  to  con- 
sider the  entries  that  would  be  made  if  the  interest  accrual  were 
recorded,  and  the  general  significance  of  such  a  policy. 

Suppose  that  a  rate  of  six  per  cent  is  used.  The  interest  ac- 
crual during  the  year  of  construction,  then,  is  $6,000.  This 
increase  in  the  value  of  the  plant  means  a  corresponding  increase 
in  the  equities  of  A  and  B.  The  entries  would  be  somewhat  as 
follows : 

Plant  (Interest  during  Construction)  ....    $6,000 

A,  Capital $3,000 

B,  Capital .     .     .•  $3,000 

These  entries  have  the  same  effect  upon  the  balance  sheet  as 
would  an  ordinary  annual  income  item  which  was  not  distributed. 
Assets  have  increased  by  $6,000,  and  proprietorship  has  increased 
by  a  like  amount.  In  other  words  the  first  year  was  not  a  lean 
year  at  all.  Income  has  actually  accrued.  Now  while  un- 
doubtedly interest  has  accrued  in  a  sense,  would  not  such  an 
accounting  policy  defeat  the  purposes  for  which  the  accounts 
are  intended?  Is  it  reasonable  to  capitalize  the  services  of  the 
owners  themselves  in  determining  the  value  of  the  property? 
The  accounts  are  kept,  it  must  be  remembered,  primarily  from 
the  standpoint  of  the  private  owners.  Then  should  not  the 
asset  accounts  show  only  the  value  of  all  services  and  commodities 
purchased  by  the  owners,  and  not  the  value  of  services  furnished 
by  themselves?  Further,  to  be  consistent  with  the  view  that 
interest  accruing  during  the  operating  period  is  not  an  expense 
but  a  distribution  of  income,  it  is  necessary  to  insist  that  interest 
accruing  on  the  investment  of  the  owners  is  never  a  capital 
charge. 

From  the  standpoint  of  the  partners  the  construction  period 
in  this  case  is  actually  a  lean  period.  No  income  accrues  in  the 
first  year.  It  is  expected,  however,  that  income  in  later  years 
will  yield  a  high  enough  rate  on  the  original  investment  to  make 
up  for  the  period  of  waiting.  To  accrue  interest  in  the  first  year 
tends  to  obscure  the  actual  business  situation.  Any  such  policy 
is  a  step  in  the  direction  of  the  elimination  of  the  fluctuations  in 


ORGANIZATION  AND   CONSTRUCTION  441 

the  rate  of  net  income.  If  the  property  account  is  charged  with 
interest  on  investment  the  actual  income  realized  in  later  years 
gives  a  smaller  rate  per  cent  on  the  value  of  the  property  than 
would  otherwise  be  the  case.  Is  it  not  more  rational  for  ac- 
counting purposes  to  assume  that  no  interest  accrues  during  the 
construction  period,  and  that  the  income  earned  in  later  years 
gives  a  correspondingly  higher  rate  on  the  actual  investment  ? 

If  the  value  of  all  of  the  services  of  the  equities  —  risk-bearing, 
waiting  and  management  —  were  considered  as  asset  charges 
year  by  year  there  would  be  no  net  revenue  at  all  in  the  ordinary 
sense.  Income  paid  to  the  owner  would  be  the  price  of  the 
owner's  service,  the  retirement  of  a  current  asset,  in  much  the 
same  way  that  the  wages  paid  to  the  laborer  are  the  price  of  the 
laborer's  service.  The  expense  for  the  year  —  the  expiration 
of  capital  assets  plus  the  value  of  commodities  and  services  pur- 
chased and  consumed  during  the  period  —  would  exactly  bal- 
ance revenues.  (It  should  be  admitted,  of  course,  that  there 
are  accidental  and  "supra-marginal"  incomes  going  to  particular 
enterprises  which  do  not  in  any  sense  represent  returns  for  serv- 
ices or  ability,  but  are  rather  economic  "rents.")  If  the  in- 
dustrial community  were  organized  as  a  gigantic  socialistic  en- 
terprise the  services  of  ownership  might  be  purchased  and  entered 
in  the  accounts  in  the  same  manner  as  all  other  items.  In  the 
present  situation,  however,  any  such  viewpoint  in  accounting 
seems  fantastic. 

To  consider  interest  accruals  or  other  phases  of  income  as  a 
part  of  the  cost  of  a  property,  in  other  words,  introduces  into  ac- 
counting the  capitalization  theory  in  an  unreasonable  manner. 
The  owners  of  a  property  expect  to  realize  a  satisfactory  return 
on  the  investment,  it  is  true,  but  in  the  typical  case  the  exact 
rate  of  return  is  not  known  and  no  return  whatever  is  assured. 
The  owners  not  only  may  not  realize  any  income  but  the  original 
investment  may  be  lost  if  the  enterprise  is  unsuccessful.  It 
cannot  be  insisted,  therefore,  that  the  value  of  the  property  is 
increasing  as  time  elapses  because  of  interest  accruals. 

There  are  some  further  considerations  on  the  other  side  of  the 
question  to  be  noted,  however,  for  if  the  partners  in  the  above 
case  actually  sell  the  completed  property  for  $106,000,  it  must 
be  admitted  that  on  the  books  of  the  buyer  the  increased  valua- 


442  PRINCIPLES  OF  ACCOUNTING 

tion  should  appear  as  an  asset.  But  the  property  is  unchanged 
by  the  sale,  it  might  be  urged,  and  is  accordingly  worth  $106,000 
before  the  transaction  occurs.  Therefore  is  it  not  being  insisted 
that  a  company  that  buys  a  completed  property  shall  prepare  its 
first  balance  sheet  on  a  different  basis  from  that  used  by  a  com- 
pany that  constructs  its  own  property?  This  seems  a  rather 
serious  objection  to  the  viewpoint  stressed  above,  and  it  can  only 
be  answered  by  saying  again  that  the  accounts  in  a  particular 
case  are  kept  primarily  to  furnish  information  to  the  particular 
owners  involved.  If  a  construction  company  builds  the  plant, 
the  operating  company  buys  the  service  of  the  construction  com- 
pany. Interest  and  profit  are  involved  in  this  price  as  in  every 
other  market  price.  This  situation  is  exactly  analogous  to  the 
purchase  of  a  finished  machine  or  any  other  asset.  The  price 
of  the  unit  covers  all  of  the  essential  economic  elements.  There 
is  still  a  serious  question,  however,  as  to  the  propriety  of  accruing 
interest  in  the  accounts  on  a  firm's  own  capital  because  of  the 
lapse  of  time.  This  means  putting  into  the  balance  sheet  the 
value  of  a  service  which  the  owners  furnish  to  themselves,  so  to 
speak. 

The  case  in  which  interest  payments  are  actually  made  to  the 
owners  during  the  construction  period  should  be  considered. 
Suppose  that  the  partners  A  and  B  mentioned  above  decide  at 
the  end  of  the  year  to  withdraw  $3,000  each  from  the  joint  funds. 
In  this  event,  evidently,  but  $94,000  would  be  invested  in  the 
property.  The  entries  recording  the  withdrawals  should  be: 

A,  Capital $3,000 

B,  Capital       $3,ooo 

Cash $6,000 

The  amount  withdrawn  cannot  still  be  considered  a  part  of  the 
cost  of  the  property.  Obviously  if  the  partners  had  not  made 
this  agreement  an  additional  $6,000  would  have  been  invested 
in  the  plant. 

Similarly  in  the  case  of  a  corporation,  dividends  paid  to  the 
stockholders  during  the  period  of  construction  cannot  be  con- 
sidered a  capital  charge.  Suppose,  for  example,  two  manufac- 
turing companies  organize  with  exactly  the  same  capitalizations, 
each  company  issuing  capital  stock  to  the  amount  of  $1,000,000 


ORGANIZATION  AND   CONSTRUCTION  443 

at  par.  In  each  case  it  requires  a  year  to  construct  the  plant. 
Company  A  pays  its  stockholders  $60,000  as  dividends  for  the 
year,  company  B  pays  no  dividends.  The  value  of  the  com- 
pleted property  in  the  first  case  is  evidently  $60,000  less  than 
in  the  second  case.  There  is  no  way  of  avoiding  this  conclu- 
sion. Company  A  has  no  advantages  market  wise  over  company 
B  because  of  the  particular  arrangement  made  with  the  stock- 
holders. 

A  complication  arises  in  the  case  of  an  enterprise  financed  with 
both  stocks  and  bonds.  Bond  interest  accrues  and  is  paid  regu- 
larly from  the  date  of  issue  if  the  company  is  not  operating. 
Such  interest  accruals  again  are  really  distributions  of  capital. 
It  can  hardly  be  said  for  accounting  purposes  that  the  payments 
made  to  the  bondholder  are  additions  to  the  value  of  the  property. 
A  comparison  between  two  companies  is  again  useful  in  this 
connection.  Company  A  is  organized  to  build  an  electric  rail- 
way line.  Its  capitalization  is  represented  by  a  stock  issue  of 
$1,000,000  and  a  bond  issue  of  $1,000,000,  and  while  the  line  and 
terminals  are  being  constructed  interest  accrues  on  the  out- 
standing bonds  and  is  disbursed  to  the  amount  of  $75,000.  Com- 
pany B  is  likewise  organized  to  build  an  electric  road.  Its  capi- 
talization is  $2,000,000  in  stock  issues,  and  no  disbursements  are 
made  to  the  stockholders  during  construction.  Obviously  com- 
pany B  will  build  more  miles  of  track  and  have  a  more  valuable 
property  than  company  A. 

The  question  now  arises  as  to  what  particular  equity  is 
affected  by  such  a  capital  withdrawal.  Referring  to  the  distinc- 
tion that  has  already  been  made  between  stockholder  and  bond- 
holder it  is  evident  that  this  burden  falls  upon  the  stockholder. 
The  stockholder  assumes  the  larger  element  of  risk,  and  conse- 
quently his  equity  is  residual  in  character.  The  attitude  of  the 
stockholder  toward  his  investment  naturally  differs  from  that  of 
the  bondholder.  The  bondholder  expects  to  receive  a  definite 
return  at  certain  specified  times ;  this  return  is  constant,  neither 
increasing  nor  decreasing.  The  stockholder,  on  the  other  hand, 
does  not  look  for  a  return  on  his  investment  during  the  con- 
struction period.  For  the  interest  lost  and  the  risk  assumed  he 
expects  to  be  compensated  in  later  prosperous  years.  He  further 
assumes  the  burden  placed  upon  the  joint  capital  because  of  the 


444  PRINCIPLES  OF  ACCOUNTING 

bondholder's  contractual  annuity.  The  stockholder  is  willing 
to  make  this  bargain  with  the  bondholder  because  his  later  in- 
come is  correspondingly  increased  due  to  the  small  rate  allowed 
the  bondholder. 

It  should  be  reiterated  emphatically  that  this  view  does  not 
conflict  with  the  well-known  economic  fact  that  interest  on  an 
investment  normally  accrues  in  time,  and  that  consequently  an 
investment  in  a  sense  accumulates  during  the  constructicn  period. 
It  is  urged,  however,  that  to  recognize  such  an  accrual  in  the 
accounts  simply  results  in  restricting  the  stated  rate  of  income 
realized  during  operation.  Such  a  practice  is  inconsistent  with 
the  theory  of  accounts  followed  in  this  text ;  and  it  would  also 
seem  to  obscure  the  practical  realities  of  the  case.  To  the  owner 
the  investment  does  not  accumulate  during  the  construction 
period  as  does  a  deposit  in  the  savings  bank.  Instead  the  rate 
which  is  realized  during  the  operating  period  is  normally  enough 
higher  to  make  up  for  the  period  of  waiting.  This  rate  is  realized, 
however,  during  the  operating  years. 

In  the  classifications  of  the  Interstate  Commerce  Commission 
already  referred  to  several  times  is  found  a  capital  account  en- 
titled "Interest  During  Construction."  This  account  is  charged 
with  all  interest  accruing  during  construction  on  bonds  and  sim- 
ilar securities  and  on  the  investment  of  the  stockholders  as  well. 
While  this  practice  is  contrary  to  the  general  view  suggested  in 
the  foregoing  discussion  it  should  be  noted  that  the  public  utili- 
ties are  not  on  an  entirely  competitive  basis.  The  rates  of  the 
railroads,  for  example,  are  regulated.  In  view  of  the  fact  that 
the  investor  in  railroad  stocks  is  restricted  pretty  largely  to  a 
non-speculative  rate  of  return  there  is  some  propriety  in  capital- 
izing the  burdens  assumed  by  the  stockholder  during  the  initial 
period  of  waiting.  It  should  further  be  noted  that  the  rules  of 
the  Commission  in  prescribing  that  interest  on  all  investment 
shall  be  charged  to  property  are  entirely  logical.  Interest  on 
bonds  and  stocks  are  properly  placed  in  exactly  the  same  account- 
ing category.1  In  a  later  chapter  some  of  the  special  problems 

1  "This  account  shall  also  include  reasonable  charges  for  interest,  during  the 
construction  period  before  the  property  becomes  available  for  service,  on  the  carrier's 
own  funds  expended  for  construction  purposes."  Classification  of  Investment  in 
Road  and  Equipment,  1914,  p.  39. 


ORGANIZATION  AND    CONSTRUCTION  445 

of  this  type  arising  in  connection  with  public  utility  accounting 
will  be  discussed. 

General  property  taxes  must  be  paid  at  stated  intervals 
whether  net  revenue  exists  or  not.  The  state's  claim  stands  prior 
to  all  private  equities.  Consequently  taxes  often  accrue  and 
are  paid  during  the  period  of  organization  and  construction. 
How  shall  such  items  be  treated  in  the  accounts  ?  Tax  payments, 
as  was  previously  explained,  constitute  a  somewhat  anomalous 
element  in  the  accounting  system.  Such  items  accruing  during 
operation  are  not  expense  in  the  ordinary  sense.  Nor  can  tax 
accruals  be  considered  as  a  distribution  to  a  typical  equity. 
Nevertheless,  as  has  been  pointed  out  the  state  virtually  has  an 
equity  in  all  taxable  property.  This  equity  has  a  recurring  char- 
acter. It  accrues  during  the  government's  fiscal  period,  and  is 
extinguished  when  the  enterprise  pays  its  taxes  only  to  accrue 
again  during  the  next  period.  If  this  accrual  were  concurrently 
recorded  in  the  accounts  the  instants  of  payment  would  be  the 
only  times  at  which  the  government's  claim  was  not  shown  in 
the  financial  records.  As  was  stated  in  Chapter  VIII  tax  ac- 
cruals are  often  recorded  at  all  periods  of  closing ;  but  this  can 
be  done  accurately  only  when  the  amount  of  the  tax  can  be 
ascertained  in  advance  of  payment. 

Tax  payments  arising  during  construction  are  usually  treated 
as  capital  charges,  and  little  fault  can  be  found  with  such  a  pro- 
cedure. Property  taxes  are  generally  levied  alike  (or  roughly  so) 
on  all  enterprises  —  operating  or  in  process  of  construction  — 
of  similar  character  and  under  the  same  governmental  jurisdic- 
tion. Accordingly,  unless  prices  are  sufficiently  high  to  cover 
all  costs  of  construction  —  including  taxes  —  capital  will  be 
withdrawn  from  the  given  industry  until  the  price  of  the  product 
rises  to  a  point  at  which  a  normal  return  on  these  outlays  is 
realized.  The  actual  investment  may  then  be  said  to  include 
tax  payments. 

It  should  be  freely  admitted  that  practically  the  same  thing 
may  be  said  about  interest  accruing  during  construction.  The 
price  of  the  product  in  later  years  will  normally  recompense  the 
investor  for  the  necessary  period  of  waiting.  Again  it  should 
be  remembered,  however,  that  the  accounts  are  kept  from  the 
standpoint  of  the  private  equities.  Tax  payments  are  a  neces- 


446  PRINCIPLES  OF  ACCOUNTING 

sary  outlay,  a  part  of  the  private  owner's  actual  investment. 
The  interest  accrual,  on  the  other  hand,  is  simply  a  phase  of  the 
owner's  return,  arising  from  the  fact  that  he  makes  these  neces- 
sary outlays  and  waits  for  his  remuneration. 


THE   CONSTRUCTION   PERIOD  —  ILLEGITIMATE   COSTS 

Thus  far  it  has  been  assumed  that  no  question  arises  as  to  the 
definition  of  the  construction  period,  but  as  a  matter  of  fact 
this  is  often  a  serious  problem.  If  the  enterprise  is  forced  to 
languish  for  long  intervals  because  of  the  lack  of  capital,  or  if 
the  actual  construction  work  is  carried  on  inefficiently,  it  would 
be  decidedly  improper  to  capitalize  the  costs  of  this  delay  and 
inefficiency.  Or  if  unusual  accidents  occur  and  retard  the  con- 
struction work,  it  would  seem  unreasonable  to  load  the  value  of 
the  property  with  such  costs. 

The  determination  of  a  proper  length  for  the  construction 
period  presents  probably  the  greatest  difficulty  in  the  case  of 
railroad  building.  The  construction  of  a  railroad  several  hun- 
dred miles  long  may  require  a  number  of  years.  In  determining 
what  is  a  proper  construction  period  in  any  case,  the  whole  situa- 
tion must  be  canvassed.  The  topographical  nature  of  the 
country  through  which  the  railroad  passes  is  an  important  factor. 
All  legitimate  obstacles  to  speedy  construction  must  be  taken 
into  consideration.  It  may  be  that  part  of  the  road  will  be  turned 
over  for  operation  before  the  entire  line  is  completed.  In  such 
a  case  the  depreciation  of  specific  property  items  and  similar 
charges  made  from  this  time  on  and  applicable  to  the  finished 
portion  of  the  property  cannot  be  considered  as  property  charges, 
but  are  rather  deductions  from  revenue. 

The  construction  period  is  sometimes  confused  with  the  "  de- 
velopmental" period.  The  following  case  illustrates  this  con- 
fusion. A  railroad  company  is  compelled  because  of  traffic 
conditions  to  change  its  route  and  abandon  one  hundred  miles  of 
track.  The  company  petitions  the  public  utilities  commission 
that  it  be  allowed  to  carry  the  cost  of  this  abandoned  property 
in  the  balance  sheet  as  an  asset,  arguing  that  the  cost  of  this 
abandoned  line  is  really  part  of  the  cost  of  the  new  road.  The 
old  line  is  analogous  to  the  "false-work"  in  a  bridge  —  a  neces- 


ORGANIZATION  AND   CONSTRUCTION  447 

sary  step  in  construction ;  the  new  road  is  analogous  to  the  com- 
pleted bridge.  This  contention  represents  a  questionable  ex- 
tension of  the  term  "construction  period."  The  interval  be- 
tween the  time  that  the  road  was  originally  turned  over  to  the 
operating  department,  and  the  date  of  the  completion  of  the  new 
line,  might  be  called  the  developmental  or  experimental  period. 
It  would  seem  unreasonable,  however,  to  consider  the  finished 
plant  as  in  the  process  of  construction  throughout  this  entire 
period.1 

It  should  be  admitted,  however,  that  it  is  not  always  easy  to 
draw  the  line  between  construction  and  operation.  The  build- 
ing of  a  modern  enterprise  is  a  more  complex  process  than  the 
mere  physical  construction  of  the  property.  It  is  necessary  to 
do  preliminary  advertising,  establish  sales  agencies,  organize 
the  operating  force,  etc.  It  would  seem  to  be  a  conservative 
policy,  however,  to  treat  practically  all  such  costs  as  operating 
charges  as  soon  as  revenue  begins  to  accrue.  There  may  then 
be  only  a  small  rate  of  net  revenue  earned  in  the  first  two  or  three 
years,  or  even  no  net  revenue.  To  extend  the  construction  period 
unreasonably,  however,  tends  again  to  inflate  property  values 
and  to  obscure  the  actual  situation. 

In  this  connection  it  should  be  emphasized  that  capital  may  be 
dissipated  as  easily  during  construction  as  at  any  other  time. 
The  management  of  a  newly  organized  company  is  naturally 
loath  to  begin  business  with  a  deficit  appearing  in  the  balance 
sheet;  but  if  the  balance  sheet  at  the  end  of  the  construction 
period  were  to  present  the  actual  status  of  the  enterprise  in  many 
cases  such  a  deficit  would  be  shown.  The  capital  of  the  investor 
is  not  in  an  inviolable  position  during  the  construction  period. 
If  the  construction  force  is  not  properly  handled  the  length  of  the 
construction  period  is  extended  beyond  a  reasonable  time,  and 
the  labor  cost  of  the  finished  plant  is  consequently  inflated.  If 
materials  are  carelessly  used  there  may  be  unusual  waste  and 
delay,  and  the  material  cost  will  be,  accordingly,  an  unreasonable 
figure.  Dishonesty  and  inefficiency  are  often  responsible  for 

1  Peculiar  problems  arise  in  railroad  accounting,  however,  as  was  stated  above, 
because  of  the  fact  of  public  regulation.  Chapter  XXXI  is  devoted  to  a  discussion 
of  some  of  these  problems.  In  Chapter  XXIV  the  significance  of  "  going  "  or 
developmental  value  will  be  considered. 


448  PRINCIPLES  OF  ACCOUNTING 

construction  figures  which  are  ridiculously  high,  and  though  all 
such  items  are  usually  charged  to  the  property  accounts  yet  this 
fact  does  not  justify  the  practice.  It  is  just  as  important  that 
the  original  values  set  upon  the  assets  taken  over  by  the  operating 
officials  should  be  correctly  stated  as  that  later  valuations  should 
be  correct. 

The  fact  that  an  actual  transaction  has  taken  place  and  that 
a  cost  has  been  incurred  does  not  of  necessity  mean  that  the  out- 
lay is  a  proper  capital  charge  even  if  the  transaction  occurs 
during  construction.  If  all  expenditures  during  organization 
and  construction  are  allowed  as  costs  of  property  the  original 
valuation  set  upon  the  assets  may  include  a  considerable  item  of 
capital  dissipation.  On  the  other  hand  any  normal,  necessary 
expenditure  for  commodities  or  services  is  allowable.  The  rep- 
resentative case  should  be  taken  as  a  basis  for  determining  the 
legitimate  values  of  newly  constructed  property  units. 

DISCOUNTS   ON   SECURITIES 

The  treatment  of  the  accounts  which  represent  the  securities 
issued  at  the  time  of  organization  requires  further  consideration 
in  this  connection.  As  was  stated  in  Chapter  XIII  it  seldom 
happens  that  the  value  of  the  property  acquired  or  constructed 
(even  when  all  legitimate  capital  costs  are  included)  exactly 
equals  the  par  value  of  the  securities  issued.  Usually  the  nominal 
capitalization  exceeds  the  actual  investment.  This  should  not 
necessarily  be  considered  an  improper  situation.  It  simply 
means  that  in  American  business  finance  it  is  somewhat  difficult 
to  issue  securities  except  at  a  discount.  It  is  customary,  however, 
to  enter  securities  in  the  accounts  at  par  and  to  inflate  property 
values  correspondingly.  Very  frequently  the  par  of  the  securities 
issued  is  taken  as  the  basis  for  the  valuation  of  the  assets  in  the 
first  balance  sheet.  The  securities  are  placed  on  one  side  of  the 
balance  sheet  at  par ;  the  asset  items  appear  on  the  other  side 
showing  the  same  total.  In  other  words  discounts  are  covered 
up  by  charges  to  property  in  an  attempt  to  validate  the  par 
value  of  the  outstanding  securities. 

Such  a  practice  is,  of  course,  entirely  improper.  In  such  a 
case  the  sums  appearing  in  the  asset  accounts  may  bear  little 


ORGANIZATION  AND   CONSTRUCTION  449 

relation  to  the  actual  value  of  the  property.  The  par  of  the  stock 
issued  is  a  formal  fact  which  reflects  investment  only  in  the 
most  general  way.  In  a  specific  case  it  may  be  a  fact  of  little 
importance.  The  reluctance  on  the  part  of  the  management  to 
show  a  valuation  item  on  the  left-hand  side  of  the  balance  sheet 
seems  to  be  responsible  for  this  practice.  If  the  situation  were 
understood  by  investors  and  others  interested  there  is  no  reason 
why  an  item  of  discount  on  stock  appearing  on  the  balance  sheet 
should  be  considered  as  a  reflection  on  the  financial  condition  of 
the  company. 

For  accounting  purposes  a  par  value  for  stock  might  well  be 
dispensed  with.  The  importance  of  par  value  in  the  accounts 
is  usually  greatly  over-emphasized.  It  would  be  entirely  pos- 
sible to  issue  securities  which  have  no  repayment  date  (such  as 
capital  stock)  without  a  stated  par  value.  It  might  be  objected 
that  capital  stock  without  a  nominal  value  could  not  be  conven- 
iently handled  in  the  accounting  records,  but  this  is  not  a  very 
serious  objection.  As  was  stated  before  no  difficulty  arises  in 
the  treatment  of  partnership  or  single-proprietor  proprietary 
accounts  because  of  the  absence  of  a  par  value  for  proprietorship. 
Without  a  par  value  a  share  of  stock  would  simply  represent  a 
certain  definite  fraction  of  the  total  of  the  stockholders'  equity. 
It  is  not  necessary  to  state  a  dividend  payment  as  a  certain  per 
cent  of  the  nominal  value  of  the  stock  outstanding.  The  sig- 
nificant fact  is  the  per  cent  of  actual  proprietorship  represented 
by  the  dividend.  Here  again  par  value  is  more  confusing  than 
illuminating.  A  dividend  declaration  may  also  be  conveniently 
expressed  at  so  many  dollars  per  share.  It  is  noticeable  that  in 
some  states  corporations  are  allowed  to  organize  without  stating 
a  par  value  for  the  capital  stock. 

If  the  par  of  the  capital  stock  appears  in  the  balance  sheet  the 
actual  amount  of  the  discount  should  be  shown  in  a  separate 
account  as  a  valuation  item.  Such  an  item  is  a  nominal  deficit 
only,  and  does  not  represent  a  dissipation  of  capital;  but  if 
actual  losses  occur  during  the  construction  period  such  items  con- 
stitute a  real  organization  deficit  as  was  previously  explained. 
In  every  case  the  values  of  the  assets  should  be  determined  by 
the  legitimate  costs  of  construction  and  organization  without 
reference  to  the  par  of  the  securities  issued. 

2  G 


450  PRINCIPLES  OF  ACCOUNTING 

Large  enterprises  frequently  make  use  of  bond  as  well  as  stock 
issues  to  secure  the  necessary  capital  as  has  already  been  explained. 
The  par  value  of  a  bond  has  a  greater  significance  than  the 
par  of  a  stock  certificate  because  it  represents  the  amount  which 
must  finally  be  paid  to  the  investor.  The  amount  of  the  discount 
is  at  the  outset  a  valuation  item,  but  the  amount  of  the  deduc- 
tion declines  as  the  liability  accrues.  The  proper  accounting 
treatment  for  items  of  bond  discount  has  been  fully  discussed 
in  preceding  chapters,  but  in  this  connection  the  point  should  be 
emphasized  that  bond  discounts  constitute  an  adjustment  in 
the  interest  rate,  and  must  not  be  considered  as  property  costs. 

Many  other  questions  arise  in  connection  with  the  valuation 
of  property  during  the  organization  and  construction  period. 
In  the  building  of  a  large  plant  the  construction  accounts  required 
may  be  a  complex  system  in  themselves.  The  valuations  set 
upon  the  assets  appearing  in  the  balance  sheet  at  the  moment 
the  completed  property  is  turned  over  to  the  operating  officials 
should  be  based  on  summaries  of  the  construction  records.  The 
nature  of  the  systems  of  construction  records  required  for  par- 
ticular types  of  work  is  a  matter  of  technique  which  cannot  be 
discussed  in  this  connection.  An  attempt  has  been  made,  how- 
ever, to  present  some  of  the  typical  and  difficult  problems  of 
analysis  which  arise  during  the  initiation  of  an  enterprise. 


XX 

THE  BASIS  FOR  REVALUATION 

IN  the  preceding  chapter  were  discussed  some  of  the  typical 
problems  arising  in  connection  with  the  valuation  of  assets  during 
or  at  the  close  of  the  organization  and  construction  period. 
These  problems  are  of  importance  particularly  in  the  case  of 
enterprises  such  as  the  public  utilities  which  require  a  long  con- 
struction period.  Of  much  wider  application  and  of  much  greater 
importance  for  the  accountant,  however,  is  the  general  problem 
of  the  revaluation  of  assets  during  the  period  of  operation.  The 
process  of  taking  inventories  and  making  appraisals  at  the  end 
of  each  regular  accounting  period  in  many  cases  furnishes  the 
manager  and  the  valuation  engineer  with  almost  insolvable 
problems;  and  the  interpretation  of  valuations  in  view  of  the 
effect  of  such  estimates  upon  the  accounts  and  the  important 
financial  statements  is  the  crux  of  the  work  of  the  accountant. 

The  fundamental  question  of  principle  that  arises  in  valuations 
concerns  the  basis  of  valuation.  In  deciding  upon  asset  values 
which  basis  shall  be  used  —  original  cost,  cost  less  depreciation, 
cost  of  replacement,  or  some  other  kind  of  present  value  ?  From 
the  standpoint  of  accounting  this  whole  matter  simmers  down  to 
a  consideration  of  the  relative  merits  of  cost  and  present  value  as 
proper  bases  for  accounting  entries  involving  valuations.  In 
referring  to  valuations  in  the  preceding  chapters  the  importance 
of  present  value  as  the  proper  basis  for  inventories  has  been 
stressed.  It  will  be  necessary  at  this  point,  however,  to  discuss 
this  question  more  fully.  Some  considerations  already  brought 
out  will  be  briefly  reviewed  and  other  aspects  of  the  problem 
heretofore  neglected  will  be  discussed  in  some  detail. 

THE   GENERAL  SIGNIFICANCE   OF  VALUE   CHANGES 

The  fluctuation  of  values  is  a  familiar  economic  fact.  De- 
pending as  they  do  upon  the  manifold  and  variable  influences 

451 


452 

which  make  up  the  industrial  situation  values  are  unstable  as- 
pects of  commodities,  services,  and  conditions.  A  value  fact 
is  never  a  permanent  fact.  Prices  on  the  market  rise  and  fall, 
and  the  values  of  objects  and  services  outside  the  regular  market 
are  subject  to  similar  disturbances. 

As  applied  to  a  specific  business  enterprise  this  means  that  the 
economic  commodities  and  rights  which  come  into  the  possession 
of  the  enterprise  are  subject  to  variations  in  value  in  either  direc- 
tion during  the  periods  of  varying  length  within  which  such 
items  remain  in  the  business.  This  statement  refers,  not  to 
changes  in  value  which  naturally  accrue  as  services  are  per- 
formed upon  an  object,  but  to  changes  due  to  general  operating 
and  economic  conditions  —  variations  resulting  from  ordinary 
wear  and  tear,  unusual  deterioration,  obsolescence,  inadequacy, 
and  changes  in  prices  or  costs  of  replacement. 

As  a  preliminary  to  the  consideration  of  the  significance  of 
these  value  changes  in  the  accounts  it  might  be  well  to  emphasize 
again  the  fact  that  accounting  deals  primarily  with  economic 
data  —  the  value  representations  of  economic  objects  and  rights. 
This  may  seem  obvious  but  it  is  a  fact  that  is  frequently  over- 
looked in  discussions  of  the  functions  of  accounting  in  connection 
with  valuations.  The  accounts  proper  show  the  values  of  things 
in  terms  of  the  money  unit.  The  physical  nature  of  an  object 
is  significant  for  the  accountant  only  in  that  it  affects  the  value 
of  the  object.  In  keeping  account  of  properties  and  equities  it 
is  of  course  necessary  to  record  and  make  use  of  auxiliary  facts 
such  as  names  of  persons,  dates,  original-document  pages,  and 
other  details ;  and  particularly  in  cost  accounting  such  subsidiary 
data  as  the  number  of  units  produced,  the  quantity  of  materials 
consumed,  and  other  physical  facts,  are  of  great  importance. 
But  the  most  important  accounting  statement,  the  balance  sheet 
(which  —  to  refer  again  to  Sprague's  statement  —  is  "the 
groundwork  of  accountancy,  the  origin  and  terminus  of  every 
account "),  is  a  statement  of  values  —  assets  and  representations 
of  ownership  or  equities  all  expressed  in  terms  of  dollars  and 
cents.  Accounting,  then,  deals  immediately  with  value  facts. 

In  determining  a  sound  accounting  policy  in  connection  with 
value  changes  it  should  be  recognized  that  an  adequate  appre- 
ciation of  the  functions  and  purposes  of  accounting  is  a  matter 


BASIS   FOR  REVALUATION  453 

of  the  first  importance.  In  a  field  such  as  accounting,  where 
one  deals  with  very  concrete  material,  general  theories  and 
principles  must  be  finally  tested  on  the  basis  of  their  practical 
utility.  It  will  therefore  be  desirable  at  this  point  to  sum  up 
briefly  the  general  functions  of  accounting  as  they  have  been 
brought  out  in  the  preceding  chapters. 

It  would  be  readily  admitted  by  all  accountants  that  it  is  at 
least  the  function  of  accounting  to  make  and  preserve  a  record 
of  the  so-called  actual  "business"  transactions.  An  accurate, 
systematic,  intelligible  record  of  contracts,  engagements  and 
authorizations  must  be  made.  It  is  necessary  to  record  invest- 
ments, withdrawals,  purchases,  sales,  etc.  In  short,  any  -happen- 
ing based  upon  some  underlying  statement  such  as  a  voucher, 
receipt,  note,  check  or  other  original  paper  must  be  recorded  and 
interpreted.  To  maintain  the  integrity  of  contracts  and  equities 
in  the  complex  enterprise,  and  to  fix  the  responsibilities  of  em- 
ployees, such  data  must  be  carefully  compiled.  This  is  account- 
ing- at  a  minimum. 

Anyone  who  is  at  all  familiar  with  the  status  of  modern  ac- 
counting, however,  must  realize  that  this  is  only  a  beginning.  A 
bare  record  of  the  so-called  actual  transactions  occurring  usually 
reflects  the  economic  history  of  an  enterprise  only  in  a  very  im- 
perfect fashion.  A  record  of  operation  —  the  internal  trans- 
actions —  is  essential.  The  status  of  commodities  and  services 
as  purchased,  as  was  stated  above,  is  only  momentarily  main- 
tained. These  economic  objects  and  rights  expire  and  pass  on 
into  other  forms.  A  record  of  these  changes  would  seem  to  be 
an  essential  part  of  the  accounting  in  any  case. 

In  other  words  the  accounting  transactions  of  a  given  period 
may  be  divided  into  two  broad  classes :  (i)  purchases  and  sales 
and  other  business  transfers  and  exchanges ;  and  (2)  accruals  of 
cost  and  income.1  A  bare  record  of  the  first  class  of  transactions 
alone  would  never  yield  a  single  accounting  statement  of  real 
importance.  The  trial  balance  is  the  only  conclusion  arising 
from  such  information.  It  is  necessary  as  was  explained  in  a 
previous  chapter  to  adjust  nearly  every  figure  appearing  in  the 

1  Accruals  of  cost  and  income  in  a  broad  sense  include  all  variations  in  the  status 
of  the  equities  resulting  from  increases  and  decreases  in  asset  values  from  whatever 


454  PRINCIPLES  OF  ACCOUNTING 

typical  trial  balance  in  order  to  prepare  an  accurate  statement  of 
expense  and  revenue,  and  an  exhibit  which  presents  the  financial 
status  of  the  enterprise  at  a  given  date.  That  is,  it  is  the  func- 
tion of  accounting  to  classify  and  interpret  the  data  of  the  busi- 
ness process  in  terms  of  distinct  periods  on  a  rational  accrual 
basis. 

All  accountants  are  agreed  that  accounting  must  go  further 
than  a  record  of  actual  transactions ;  and  they  are  further  agreed 
that  all  accruals  of  cost  —  including  the  accrued  expirations  of 
all  assets  —  should  be  charged  against  revenues  in  ascertaining 
net  revenue  for  a  given  period.  Depreciation  —  the  value  ex- 
piration of  assets  —  is  not  only  admitted  to  be  a  proper  matter 
for  accounting  record,  but  it  is  insisted  that  it  should  be  booked. 


.It  is  recognized  that  the  maintenance  of  capital  does  not  depend 


simply  upon  the  number  of  property  units  possessed.  The 
investment  in  any  case  is  an  economic  fact ;  and  unless  the  assets 
in  which  the  investment  is  represented  are  valued  on  an  accrual 
basis  the  equities  in  the  investment  will  also  be  incorrectly  stated. 
On  the  other  hand  the  consensus  of  opinion  is  distinctly  against 
the  recognition  of  appreciation  —  increases  in  asset  values  — 
as  an  accounting  fact  except  in  so  far  as  such  changes  appear  in 
actual  purchase  and  sale  occurrences. 

The  fact  that  there  is  this  array  of  opinion  opposed  to  the  prac- 
tice of  accounting  for  appreciation  might  be  considered  as  prima 
facie  evidence  that  there  is  very  good  reason  for  this  doctrine, 
and  hence  that  any  argument  against  it  might  as  well  be  aban- 
doned at  the  outset.1  This,  however,  would  be  an  unwarranted 
conclusion.  It  may  be  that  the  minority  opinion  is  right.  One 
needs  to  go  back  but  fifteen  or  twenty  years  in  accounting  and 
judicial  opinion  to  find  serious  question  raised  as  to  the  legiti- 
macy of  recognizing  the  accrued  depreciation  of  fixed  assets  as 
an  expense.  Indeed  it  has  taken  some  time  for  accounting 
opinion  to  develop  to  the  point  of  recognizing  that  the  operating 
expense  of  a  given  period  is  not  synonymous  in  meaning  or  numeri- 
cally identical  (usually)  with  the  cash  outlay  for  the  period.  As 
stated  above,  however,  accountants,  courts  and  commissions  are 
now  almost  unanimous  in  their  opinion  that  accrued  depreciation 

1  The  weight  of  legal  opinion  also  supports  the  view  that  accrued  appreciation 
should  not  be  booked. 


BASIS  FOR  REVALUATION  455 

should  be  booked  as  an  operating  expense.  It  seems  reasonable, 
then,  to  at  least  raise  a  query  as  to  the  validity  of  present  opinion 
in  regard  to  accrued  appreciation. 

There  is  little  question  as  to  the  logic  of  the  case.  There  is  no 
peculiar  virtue  in  either  the  increase  or  decrease  of  values.  Ac- 
countants quite  generally  admit  the  inconsistency  of  their  posi- 
tion ;  but  they  urge  that  certain  practical  considerations  justify 
this  inconsistency.  In  the  following  sections  the  more  impor- 
tant of  these  considerations  will  be  discussed. 

The  effect  of  the  recognition  of  depreciation  and  appreciation 
upon  the  net  revenue  figure  was  sufficiently  emphasized  in  Chap- 
ter X.  It  was  'shown  that  until  all  value  accruals  in  both  direc- 
tions are  taken  into  account  it  is  not  possible  to  prepare  either 
an  accurate  income  sheet  or  an  accurate  balance  sheet.  The 
point  was  emphasized,  moreover,  that  the  maintenance  of  the 
integrity  of  the  accounting  period  depends  upon  the  recognition 
of  all  changes  as  they  accrue.1  In  the  present  chapter  these 
matters  will  be  neglected,  and  other  important  phases  of  the 
problem  will  receive  particular  attention. 


VALUATION  AND  MANAGEMENT 

In  general  it  may  be  said  that  all  of  the  interests  2  involved  in 
the  business  enterprise  are  furthered  by  efficiency  in  production. 
Efficient  management  is  of  advantage  to  all  concerned.  Ac- 
cordingly one  of  the  most  important  phases  of  modern  accounting 
involves  the  uses  to  which  accounts  and  other  statistical  records 
may  be  put  to  serve  managerial  purposes.  In  this  section  will 
be  considered  the  question  as  to  which  basis  for  valuation,  cost 
or  cost  of  replacement,  has  the  greater  significance  for  the 
manager. 

What  is  the  task  of  management?  In  the  broadest  sense  it 
is  the  function  of  the  financial  and  operating  managers  to  make 
the  most  efficient  possible  use  of  the  economic  resources  at  their 

1  At  this  point  the  student  would  do  well  to  review  the  last  section  of  Chapter  X. 

/       2  As  has  been  emphasized  several  times  in  this  text  it  is  the  immediate  function  of 

accounting,  in  the  ordinary  competitive  enterprise,  to  advance  the  interests  of  the 

private  owners.     The  interests  of  the  prospective  investor  or  creditor,  of  the  laborer, 

and  of  the  public  are,  of  course,  involved. 


456  PRINCIPLES  OF  ACCOUNTING 

disposal ;  and  it  is  generally  admitted  that  it  is  from  the  accounts 
and  underlying  records  that  the  general  manager,  in  large  meas- 
ure, must  draw  the  information  which  shall  enable  him  to  ac- 
complish this  task.  To  be  of  the  utmost  assistance  to  the  man- 
ager in  this  connection  what  should  the  accounts  show  —  the 
present  significances  of  all  assets  as  nearly  as  these  facts  may 
be  ascertained  or  some  other  figures?  There  are  at  least  some 
reasons  for  thinking  that  present  values  are  the  all-important 
consideration.  It  is  not  the  cost  of  the  building  or  power-unit 
or  machine  which  is  most  significant  to  the  manager  interested 
in  a  wise  utilization  of  available  resources.  It  is  rather  the  cost 
of  replacement  which  must  form  the  basis  of  his  reckoning.  Sup- 
pose, for  example,  that  a  machine  which  cost  $8,000  is  purchased 
and  installed.  A  little  later  another  machine  is  purchased  which 
is  similar  in  every  respect  to  the  first  machine  and  will  be  used 
for  the  same  purpose.  Market  conditions  have  changed,  how- 
ever, and  this  time  the  cost  is  $9,000.  Can  the  manager  who 
looks  merely  at  original  figures  in  such  a  case  make  rational 
decisions?  By  assumption  there  is  no  physical  difference  be- 
tween the  two  units  —  is  there  any  economic  difference  ?  Can 
the  manager  say  that  the  capital  cost  of  producing  the  product 
involved  is  less  per  unit  in  the  case  of  the  first  machine  than  in 
the  case  of  the  second  ? l  It  would  seem  that  the  manager  must 
recognize  the  fact  that  he  now  has  at  his  disposal  economic  re- 
sources (capital)  amounting  not  to  $17,000  but  to  $18,000. 

An  advance  in  the  price  of  raw  materials  furnishes  a  better 
illustration  of  the  importance  of  present  values  for  managerial 
purposes.  Suppose  that  a  company  manufacturing  special  types 
of  copper  wire  and  cables  has  stocked  up  on  raw  copper  in  1914 
at  low  prices.  Within  six  months,  it  will  be  assumed,  the  price  of 

1  The  retailer  sometimes  appears  to  reason  in  this  way.  He  has  on  the  shelves, 
for  example,  two  shipments  of  canned  goods  which  are  identical  in  every  respect 
but  which  cost  seventeen  cents  and  nineteen  cents  per  can  respectively.  He  now 
argues  that  he  can  sell  from  the  seventeen-cent  lot  at  a  little  lower  figure  than  from 
the  nineteen-cent  shipment  because  he  made  the  first  purchase  before  the  advance 
in  wholesale  prices  occurred.  Since  the  units  are  interchangeable  such  a  method  of 
pricing  seems  entirely  irrational.  It  is  noticeable  that  the  merchant  in  such  a  case 
usually  is  careful  to  tell  the  customer  all  about  the  sacrifice  he  is  making,  wJiich  is  in 
itself  evidence  of  its  unreasonableness.  In  fact  this  is  generally  simply  a  particular 
method  of  advertising.  Probably  in  the  great  majority  of  cases  cost  of  replacement 
is  effective  in  setting  prices  even  in  the  retail  market. 


BASIS   FOR  REVALUATION  457 

• 

copper  has  advanced  fifty  per  cent.  But  the  manager,  reasoning 
from  the  data  appearing  in  the  merchandise  accounts,  argues  that 
the  company  can  still  profitably  manufacture  its  old  product 
although  the  price  of  that  product  has  remained  stationary. 
Would  this  be  making  a  wise  use  of  the  company's  economic 
resources  ?  Meanwhile  certain  other  products  more  immediately 
connected  with  the  carrying  on  of  war  have  likewise  advanced 
sharply  in  price.  The  company  might  well  turn  its  attention  to  the 
new  lines.  Both  the  interests  of  the  owners  and  of  the  community 
would  be  thereby  advanced  (assuming,  of  course,  that  the  market 
at  least  approximately  expresses  the  needs  of  the  community). 

It  may  be  urged,  however,  that  although  market  conditions 
are  of  importance  these  matters  need  not  affect  the  accounts, 
that  the  manager  in  any  case  will  naturally  be  cognizant  of  the 
situation  and  will  act  accordingly.  Yet  this  is  hardly  a  reasonable 
position  since  it  is  generally  admitted  that  it  is  an  important 
function  of  the  financial  accounts  to  furnish  information  which 
will  assist  the  management  in  making  rational  decisions  regard- 
ing the  employment  of  the  investor's  capital.  Further,  it 
is  always  insisted  that  depreciation  due  to  changes  in  market 
conditions  should  be  booked. 

In  the  case  of  most  fixed  assets,  value  declines  due  to  the  various 
important  factors  contributing  to  depreciation  —  wear  and  tear 
in  use,  extraordinary  deterioration  and  damage,  obsolescence, 
etc.  —  usually  more  than  offset  any  possible  appreciation  due  to 
changes  in  construction  costs.  And  in  such  cases  it  is  admitted 
that  present  value  (cost  less  net  depreciation)  is  the  significant 
accounting  figure  for  managerial  and  other  purposes.  It  may 
well  be  asked :  if  present  value  is  significant  in  these  cases,  why 
is  this  not  the  case  where  increasing  costs  of  replacement  have 
more  than  offset  the  depreciation  tendency  ?  Even  if  deprecia- 
tion is  the  stronger  influence,  in  any  case  it  is  important  to  notice 
that  the  appreciation  tendency  may  necessitate  an  occasional 
revision  of  the  rate  of  depreciation.  The  economic  life  of  a  freight 
car,  for  example,  does  not  depend  merely  upon  the  ordinary 
depreciation  factors  but  upon  cost-of-replacement  conditions  as 
well.  A  particular  car  might  last  fifteen  years  and  be  scrapped 
at  the  end  of  that  period  provided  there  were  no  changes  in  prod- 
uct prices  or  in  replacement  costs.  If  labor  and  material  costs 


458  PRINCIPLES  OF  ACCOUNTING 

advance,  however,  the  management  may  very  wisely  decide  to 
use  the  car  twenty  years.  In  the  revaluation  of  assets  the  ac- 
countant usually  admits  the  propriety  of  allowing  for  price 
increases  provided  this  influence  does  not  entirely  offset  deprecia- 
tion. This  is  nothing  more  nor  less  than  the  recognition  of  ap- 
preciation in  a  limited  sense.  If  price  changes  may  be  allowed 
to  revise  the  rate  of  depreciation,  why  should  the  validity  of 
price  changes  which  entirely  offset  depreciation  be  questioned? 
This  is  only  one  illustration  of  the  way  in  which  appreciation 
under  present  practice  gets  into  the  accounts  in  an  imperfect 
fashion. 

Land  furnishes  an  important  exception  to  the  general  rule 
that  the  fixed  assets  are  subject  to  net  depreciation.  In  general 
all  land  properties  rise  in  value  with  the  industrial  growth  of  the 
community.  Is  present  value  the  significant  thing  here  for 
managerial  purposes?  While  land  may  not  contribute  a  price- 
determining  cost  from  the  standpoint  of  the  general  market, 
from  the  standpoint  of  the  specific  enterprise  land  is  virtually 
in  the  same  category  as  capital.  Those  economists  who  have 
attempted  to  extend  the  concept  of  capital  to  include  land  have 
always  argued  from  this  viewpoint.  The  manager,  then, 
considers  land  as  of  essentially  the  same  character  as  any  other 
asset — a  part  of  the  capital  cost.  In  determining  what  economic 
resources  are  being  devoted  to  a  particular  end  land  must  then 
be  taken  into  consideration ;  and  if  present  values  are  not  recog- 
nized the  accounts  will  not  be  of  much  service  in  this  connection. 
Economic  resources  are  always  -measured  in  terms  of  present 
values. 

It  is  sometimes  objected  that  if  a  factory  site,  for  example, 
appreciates  because  of  an  advance  in  the  prices  of  contiguous 
property,  it  does  not  add  anything  to  the  physical  efficiency  of 
the  site  for  manufacturing  purposes,  and  hence  the  increment 
should  not  be  registered  in  the  accounts.1  This  objection 
appears  to  involve  the  old  confusion  between  utility  and 
value,  or,  at  least,  is  based  on  the  failure  to  appreciate  the 

1  Montgomery  in  his  "Auditing"  takes  the  position  that  in  the  case  of  land  cost 
should  always  be  shown  in  th'e  accounts  whether  present  value  is  lower  or  higher  on 
the  ground  that  an  appreciated  or  depreciated  site  is  no  more  nor  less  valuable  for 
the  specialized  purpose  to  which  it  is  being  put  than  it  was  when  purchased.  This 


BASIS   FOR  REVALUATION  459 

fact  that  accounting  deals  with  economic  data.  If  all  similar 
sites  have  risen  in  value,  an  advance  in  the  price  of  the  product 
will  accompany  this  change.  If  only  the  value  of  a  particular 
site  has  increased,  due  to  conditions  entirely  outside  of  the  in- 
dustry involved,  this  fact  should  be  recognized  in  the  accounts 
so  that  the  management  may  realize  the  situation,  and  either 
make  more  efficient  use  of  the  property  or  move  the  enterprise 
as  soon  as  feasible  to  a  cheaper  site.  It  is  largely  due  to  the 
recognition  of  such  value  changes  that  the  continuous  shifting 
of  economic  resources  so  essential  to  general  industrial  welfare 
is  accomplished.  In  the  case  of  the  appreciated  factory  site  it 
is  evident  that  a  piece  of  land  is  being  devoted  to  a  purpose  for 
which  it  is  too  valuable  —  either  from  the  standpoint  of  public 
or  private  interest. 

This  point  can  be  made  emphatic  by  the  consideration  of  a 
rather  extreme  case.  In  a  certain  large  city  a  small  weather- 
beaten  structure  used  as  a  repair  shop  is  located  in  the  "down- 
town" district,  surrounded  by  modern  buildings.  The  site  was 
purchased  many  years  ago  for  about  $1,000.  On  the  basis  of 
the  value  of  contiguous  property  the  site  is  now  worth  about 
$25,000.  Should  the  owner  of  the  shop  consider  the  land  as  still 
worth  but  $1,000  on  the  ground  that  this  is  the  cost  figure  and 
that  the  site  is  no  more  valuable  for  his  purpose  than  it  was  for- 
merly (assuming  this  to  be  true)  ?  Would  not  such  an  opinion 


is  at  least  a  logical  standpoint  but  such  a  view  denies  that  it  is  the  function  of  the 
accounts  to  show  economic  facts.  Montgomery's  argument  against  the  validity  of 
recognizing  an  increased  valuation  in  land  is  interesting.  He  urges  that  not  only 
is  an  increase  in  site  values  not  a  benefit  to  a  manufacturing  company  but  it  is  an 
actual  detriment  because  of  the  increased  taxes  which  are  likely  to  follow.  In 
much  the  same  sense  it  might  be  said  that  any  increase  in  capital  costs  is  a  detriment. 
If  it  costs $2,000  more  to  replace  a  machine  than  the  original  cost  of  the  unit  removed, 
it  is  clear  that  the  capital  cost  of  producing  the  commodity  or  service  involved  has 
increased.  It  is  just  such  facts,  however,  which  the  management  wishes  to  know 
and  which  should  be  shown  by  the  accounts.  Similarly  if  an  asset  declines  in  value 
this  fact  should  be  recognized,  although  the  physical  efficiency  of  the  asset  may  be  as 
great  as  before.  Obviously  a  once  valuable  tract  of  land  might  become  worthless 
because  of  industrial  and  market  changes,  although  its  usefulness  for  the  particular 
purpose  for  which  it  was  secured  were  unimpaired.  If  an  item  has  actually  lost 
its  economic  character  it  no  longer  represents  a  part  of  the  capital  of  the  business  and 
may  be  entirely  omitted  from  the  balance  sheet.  It  should  be  noted,  however,  that 
in  a  few  cases  an  item  may  have  an  actual  economic  significance  to  a  particular 
enterprise,  although  it  has  no  general  market  value. 


460  PRINCIPLES  OF  ACCOUNTING 

be  entirely  irrational  and  impractical,  and  be  judged  as  due  to 
obstinacy  or  other  eccentricity  ? 

Another  phase  of  the  relation  between  management  and  the 
accounts  lies  in  the  uses  to  which  the  records  may  be  put  by  those 
ultimately  in  authority  in  determining  the  efficiency  of  the  oper- 
ating officials.  The  accounts  can  be  made  an  effective  tool  in 
fixing  the  responsibilities  of  the  manager  and  other  employees, 
and  may  be  used  to  some  extent  as  an  index  of  efficiency  to  guide 
the  directors  and  owners  in  their  judgments.  It  was  suggested 
in  Chapter  X  (page  242)  that  in  some  cases  this  can  be  more 
effectively  accomplished  by  the  recognition  of  appreciation. 
Another  illustration  will  be  given  at  this  point.  During  1914,  A, 
it  will  be  assumed,  is  manager  for  the  X  Co.  The  war  interferes 
with  sales  and  hence  there  is  a  poor  showing  of  revenue.  A, 
however,  stocks  up  with  raw  materials  during  August  and  Sep- 
tember at  very  favorable  prices.  By  December  business  has 
revived  somewhat  and  the  prices  of  materials  have  advanced. 
It  would  now  cost  the  X  Co.  $200,000  additional  to  buy  its  stock 
of  materials.  The  directors,  however,  dissatisfied  with  A's 
showing  dismiss  him  and  engage  B.  During  1915  the  business 
revival  continues,  and  B  makes  an  exceedingly  favorable  showing 
of  net  revenue  for  the  year.  Of  this  amount  $200,000  is  clearly 
due  to  A's  foresight.  If  these  accounts  are  to  be  used  to  reflect 
managerial  efficiency  it  would  seem  that  appreciation  of  mate- 
rials to  the  amount  of  $200,000  should  be  credited  to  the  revenue 
of  1914.  (This  situation,  of  course,  is  a  special  case.  The 
manager  may  or  may  not  be  responsible  for  unusual  gains  or 
losses.) 

Much  more  might  be  said  concerning  the  significance  of  present 
values  for  general  managerial  purposes.  The  suggestions  made 
would  seem  at  least  to  raise  a  substantial  query  as  to  the  reason- 
ableness of  keeping  accrued  appreciation  out  of  the  records.  Can 
the  manager  intelligently  choose  between  methods,  processes, 
machines,  products,  on  the  basis  of  historical  figures?  Should 
he  not  base  his  decisions  upon  a  recognition  of  the  present  sig- 
nificance of  all  commodities  and  services  available?  And  if 
the  accounts  are  to  be  used  by  the  manager  —  should  not  this 
information  be  presented  in  the  accounts? 


BASIS   FOR   REVALUATION  461 


THE  MEASUREMENT   OF  INVESTMENT   OR   SACRIFICE 

An  objection  to  the  recognition  of  appreciation  in  the  accounts 
to  which  particular  attention  has  been  directed  in  discussions 
of  public  utility  accounting  and  also  of  general  accounting  is 
based  upon  the  contention  that  the  accounts  should  show  cost 
figures  because  cost  represents  the  investment  or  sacrifice  of  the 
investor.  The  validity  of  this  viewpoint  may  be  questioned  on 
two  bases.  In  the  first  place  cost  figures  as  ordinarily  under- 
stood do  not  show  the  actual  sacrifice  of  the  investor ;  and  in 
the  second  place,  it  is  doubtful  if  it  is  the  function  of  the  accounts 
to  present  at  all  times  original  sacrifice.  Each  of  these  propo- 
sitions will  be  briefly  considered. 

Original  cost  figures  would  permanently  show  the  sacrifice 
of  the  investor  only  in  a  regime  of  static  prices  ;  and  the  shifting 
of  prices  is  an  important  and  familiar  characteristic  of  the  modern 
economic  order.  These  general  changes  reflect  a  change  —  rela- 
tive or  absolute  —  in  •  the  measuring  unit  itself.  The  dollar, 
as  is  the  case  with  all  value  units,  is  not  a  unit  of  constant  sig- 
nificance. As  prices  in  general  advance  the  significance  of  the 
dollar  declines  and  vice  versa.  Consequently,  in  a  system  of 
shifting  prices,  original  cost  (in  dollars)  does  not  show  original 
sacrifice.  Suppose,  for  example,  that  $100,000  in  capital  is 
invested  in  a  manufacturing  enterprise  in  IQIO.  This  means 
$100,000  in  terms  of  IQIO  dollars.  If  in  1917  prices  in  general 
have  advanced  forty  per  cent  this  means  —  ignoring  deprecia- 
tion —  that  in  terms  of  igif  dollars  the  actual  investment  or 
sacrifice  of  the  stockholders  is  $140,000  rather  than  $100,000. 
Thus  the  importance  of  original  cost  figures  —  as  representing 
sacrifice  —  disappears  in  large  measure  in  a  period  of  changing 
prices.  Moreover,  prices  are  always  changing.  In  accounting 
there  is  little  propriety  in  the  assumption  of  static  prices. 

In  order  to  follow  original  sacrifices,  then,  it  would  be  neces- 
sary to  recognize  changes  in  the  significance  of  the  money  unit 
in  the  accounts.1  But  it  is  very  doubtful  if  the  accounts  should 
show  original  sacrifice.  It  has  been  argued  thus  far  that  costs 

1  In  Should  Accounts  Reflect  the  Changing  Value  of  the  Dollar?,  Journal  of  Account- 
ancy, issue  of  February,  1918,  Livingston  Middleditch  suggests  a  way  in  which  this 
may  be  done. 


462  PRINCIPLES  OF  ACCOUNTING 

of  replacement  should  form  the  basis  for  the  revaluation  of  assets 
for  accounting  purposes  ;  and  actual  sacrifice  and  cost  of  replace- 
ment are  not  likely  to  coincide.  The  change  in  the  value  of  the 
dollar  reflects  general  price  changes.  But  it  is  not  values  in 
general  but  specific  values  which  the  accounts  should  show. 
The  accounts  of  an  enterprise  should  present  as  nearly  as  possible 
the  actual  values  of  the  specific  assets  which  make  up  its  invest- 
ment. Cost  figures,  properly  adjusted  to  allow  for  changes  in 
the  money  unit,  give  a  correct  expression  of  the  original  invest- 
ment. Cost  of  replacement  figures,  with  proper  allowances  for 
depreciation,  give  present  values. 

An  illustration  will  perhaps  serve  to  make  the  distinction 
between  present  value  and  sacrifice  figures  entirely  clear.  The 
A  Company  buys  a  shipment  of  raw  materials  at  the  beginning 
of  the  year.  The  cost  is  $25,0x30.  At  this  time  this  figure  rep- 
resents the  investment  of  the  owners  and  actual  value  as  well. 
Within  three  months  a  general  price  movement  has  occurred 
which  means  a  depreciation  in  the  significance  of  the  dollar  of 
twenty-five  per  cent.  This  corresponds  to  an  advance  in  general 
prices  of  thirty-three  and  one-third  per  cent.  Expressed  in  terms 
of  the  new  dollar,  then,  the  above  shipment  of  materials  would 
have  a  value  of  $33,333-33.  This  figure  represents  the  sacrifice 
of  the  investor  in  terms  of  the  current  dollar.  It  is  very  unlikely, 
however,  that  the  cost  of  replacement  of  this  particular  com- 
modity has  advanced  in  exact  proportion  to  general  price  change. 
The  price  of  the  materials  involved  may  have  advanced  fifty  per 
cent,  for  example.  The  values  of  all  commodities  and  services 
do  not  rise  and  fall  evenly.  A  particular  commodity  may  even 
fall  in  price  although  the  general  movement  is  in  the  opposite 
direction.  Accordingly,  if  the  property  accounts  are  used  to 
represent  the  values  of  the  specific  assets  involved,  in  any  case  it 
is  specific  and  not  general  price  changes  which  are  significant, 
and  the  figures  which  represent  original  sacrifice  will  not  be 
maintained. 

It  is  the  function  of  the  asset  accounts  to  follow  the  capital 
investment  of  the  owner  as  it  takes  shape  in  different  units  and 
types  of  property.  Subject  as  it  is  to  the  varying  conditions  in 
the  economic  situation  this  investment  may  increase  or  decrease, 
reflecting,  of  course,  a  corresponding  increase  or  decrease  in 


BASIS   FOR  REVALUATION  463 

ownership.  If  it  were  true  that  the  actual  capital  of  the  investor 
was  not  subject  to  change  because  of  technical  and  economic 
conditions,  then  it  would  be  the  function  of  the  accounts  to  show 
at  all  times  original  sacrifice.  But  this  does  not  at  all  conform 
to  the  realities  of  the  case.  A  given  capital  fund  may  be  entirely 
dissipated  because  of  business  losses.  Of  what  importance  would 
it  be  in  such  a  case  to  present  original  sacrifice  figures  in  the 
property  accounts  ?  Another  fund  of  capital  may  be  doubled  in 
a  few  years  because  of  successful  management  or  accidental 
circumstances.  Similarly  in  this  case  original  investment  is 
not  the  proper  basis  for  asset  valuations.  No  fund  of  capital  is 
actually  static  in  a  dynamic  economic  situation. 

The  discussion  in  the  preceding  paragraphs  refers  to  the  com- 
petitive enterprise.  In  the  case  of  publicly  regulated  enterprises, 
where  rates  are  not  market  prices,  there  are  other  elements  to 
be  considered  in  determining  the  proper  basis  for  valuations  for 
accounting  purposes.  The  courts  have  held  that  the  investor 
in  public  utilities  is  entitled  to  a  "fair"  return  on  a  fair  value  of 
the  property  in  any  case.  The  question  as  to  what  constitutes 
such  a  fair  value  is  still  unsettled.  Undoubtedly  the  original 
sacrifice  of  the  investor  is  a  matter  of  greater  significance  in  such 
cases  than  in  the  case  of  the  typical  competitive  enterprise.  In 
Chapter  XXXI  this  problem  will  be  discussed. 

SPECIAL  OBJECTIONS  TO   THE   RECOGNITION   OF  APPRECIATION 

It  may  be  said  that  to  recognize  the  appreciation  of  either 
fixed  or  current  assets  is  unwise  because  it  may  be  necessary  to 
revise  the  estimates  if  prices  fall.  This  objection  does  not  seem 
to  be  very  serious  because  the  same  thing  may  be  said  of  any 
asset  value ;  and  it  may  be  said  of  original  cost  as  well  as  of  ap- 
preciated value.  All  asset  values  are  more  or  less  uncertain,  or, 
in  other  words,  are  subject  to  revision.  A  factory  which  costs, 
$1,000,000  to  build  may  become  nearly  worthless  within  a  short 
time  due  to  the  exigencies  of  the  economic  situation ;  but  it  would 
not  be  wise,  therefore,  to  anticipate  bankruptcy  and  enter  the 
cost  of  the  structure  as  a  deficit  in  the  first  place.  It  is  the 
function  of  the  accounts  to  follow  just  such  changes.  If  an 
equity  is  impaired  through  asset  losses  in  one  year  the  accounts 


464  PRINCIPLES  OF  ACCOUNTING 

should  show  that  fact.  If  the  loss  is  recouped  in  a  later  period 
the  accounts  should  show  the  change  and  in  the  proper  period. 
Business  fortunes  vary  from  year  to  year.  The  accounts  should 
present  these  variations. 

In  this  connection  the  importance  of  recognizing  appreciation 
in  order  to  maintain  the  integrity  of  the  accounting  period  should 
be  reemphasized.  The  emphasis  upon  the  period  is  one  of  the 
striking  characteristics  of  modern  accounting.  In  order  that 
periods  may  be  separated  sharply  trial  balance  figures  are  ad- 
justed on  an  accrual  basis.  Inventories  of  goods  in  process  and 
finished  goods  are  taken.  Costs  applicable  to  such  goods  are 
included  in  these  inventory  figures  so  that  deductions  from  sales 
for  the  period  will  not  be  overstated.  Similarly  revenues  are 
accrued.  It  is  considered  to  be  good  practice  in  contractors' 
accounts,  for  example,  to  apportion  sales  figures  over  the  entire 
period  of  construction.  All  of  these  accruals  are  recognized  to 
maintain  the  integrity  of  the  period.  To  carry  this  procedure 
to  its  logical  conclusion  it  would  seem  reasonable,  then,  to  accrue 
appreciation  of  raw  materials,  for  example,  instead  of  waiting 
until  a  sale  is  made. 

Another  argument  always  raised  against  the  practice  of  ap- 
preciating unsold  assets  is  that  such  a  procedure  anticipates 
profits.  (See  Chapter  X.)  This  argument  is  entirely  fallacious. 
To  use  selling  prices-  in  taking  inventories  —  in  other  words  to 
capitalize  the  services  of  the  firm  before  those  services  are  per- 
formed —  is  to  anticipate  profits.  To  recognize  changing  capi- 
tal costs  and  equity  changes  due  to  the  appreciation  of  working 
or  fixed  assets  is  an  entirely  different  thing.  Suppose,  for  ex- 
ample, that  materials  on  the  shelves  cost  fifty  cents  per  unit  and 
that  cost  of  replacement  becomes  sixty  cents.  This  is  appre- 
ciation. To  inventory  these  materials  at  eighty  cents  —  selling 
price  —  would  be  to  forecast  profits. 

This  argument  comes  up  in  various  forms.  Sometimes  it  is  said 
that  appreciation  is  "unrealized  profit."  This  is  again  unsound. 
Suppose  that  an  individual  owns  a  bond  and  that  it  advances  in 
value.  The  profit  has  been  realized  in  the  ordinary  accounting 
sense  although  a  sale  has  not  been  made.  All  accruals  are,  of 
course,  based  on  "unrealized"  transactions.  Accruals  of  cost 
in  connection  with  goods  in  process  and  finished  goods,  and  ac- 


BASIS  FOR  REVALUATION  465 

cruals  of  revenue  in  connection  with  an  industry  like  shipbuilding 
are  all  in  this  class.  None  of  these  accruals  are  yet  realized  in 
cash.  On  the  other  hand  a  revenue  realized  in  cash  may  not  be 
a  revenue  within  the  period  covered  by  the  cash  transactions. 
A  railroad  company,  for  example,  sells  excursion  tickets  in  one 
month  and  takes  them  up  in  the  next.  The  revenue  accrues  as 
the  service  is  rendered.  This  objection  seems  to  be  based  on 
the  old  fallacy  that  a  profit  must  be  available  in  cash  before  it 
can  be  recognized. 

Again  it  is  contended  that  appreciation  is  only  an  estimate  and 
hence  that  it  is  not  practicable  to  recognize  it  in  the  accounts. 
In  answering  this  objection  it  should  first  be  roundly  emphasized 
that  accounting  deals  primarily  not  with  absolute  certainties 
but  with  estimates.  Every  valuation  is  an  estimate.1  All 
inventories  are  estimates.  Depreciation  is  purely  a  question  of 
estimates,  and  yet  no  one  argues  that  accrued  depreciation  should 
be  omitted  from  the  accounting  records. 

As  a  matter  of  fact,  moreover,  the  value  of  an  appreciated 
asset  can  be  estimated  more  accurately  than  a  valuation  taken 
on  any  other  basis.  In  the  case  of  land  appreciation,  for  example, 
the  market  for  contiguous  property  gives  a  fairly  reliable  indica- 
tion of  the  present  value  of  any  particular  site.  But  to  estimate 
the  depreciation  of  a  factory  or  a  machine  is  the  most  difficult 
problem  in  accounting.  Such  a  valuation  is  largely  guess.  There 
is  no  reliable  market  for  second-hand  factories.  Similarly  in 
connection  with  working  assets  and  other  current  items,  present 
values  in  the  case  of  advances  are  easily  ascertained.  The  current 
wholesale  prices  for  materials,  for  example,  can  be  determined 
on  as  reliable  a  basis  as  can  actual  invoice  prices.  The  value 
expiration  of  merchandise  due  to  deterioration  and  shopwear, 
on  the  other  hand,  is  very  hard  to  measure. 

In  this  connection  it  may  be  further  objected  that  present 
value  has  so  many  different  connotations  that  it  does  not  form  a 
reasonable  basis  for  valuations.  Present  value,  for  example, 
may  mean  a  possible  cash  liquidating  value  or  it  may  mean  the 

1  In  this  connection  it  may  be  noted  that  the  practice  of  some  auditors  who  spend 
a  great  deal  of  time  endeavoring  to  locate  a  small  error  in  the  trial  balance,  and  then 
readily  certify  to  valuations  in  the  balance  sheet  involving  hundreds  of  thousands 
of  dollars  is  somewhat  unreasonable. 


2H 


n 

466  PRINCIPLES  OF  ACCOUNTING 

cost  of  replacement.  The  idea  of  the  "going  concern"  has  con- 
siderable significance  in  this  connection.  Usually  it  may  be 
taken  for  granted  that  the  enterprise  involved  will  continue  to 
operate,  buying  materials  and  selling  finished  goods,  and  that 
therefore  the  cost  of  replacement  value  is  the  significant  thing. 
As  a  rule  cost  of  replacement  is  higher  than  the  amount  which 
would  be  received  at  a  forced  sale.  In  the  case  of  such  assets  as 
securities,  however,  liquidating  value  and  replacement  cost  are 
essentially  the  same.  The  "kind"  of  present  value  to  be  used  in 
making  valuations  depends  upon  the  condition  of  the  enterprise 
and  the  purpose  of  the  valuation  in  any  case.  It  is  usually  not 
very  difficult  to  come  to  a  rational  decision.  Valuations  on  a 
cost  basis  furnish  much  more  difficult  problems  of  analysis  as 
will  be  explained  in  the  next  chapter. 

In  the  same  vein  it  may  be  urged  that  to  introduce  hypothetical 
values  into  the  accounts  is  not  a  reasonable  procedure  in  itself. 
This  point  can  be  made  in  a  particularly  effective  way  in  con- 
nection with  the  revaluation  of  a  fixed  asset  such  as  land.  Can 
the  values  of  contiguous  property  be  used  as  a  proper  basis  in 
revaluing  a  factory  site  ?  The  factory  site  will  probably  not  come 
into  the  market  at  all  for  years.  The  sales  of  contiguous  property 
may  be  for  residence  or  other  purposes.  Do  these  sales  neces- 
sitate a  revision  of  the  value  of  a  site  used  for  an  altogether  dif- 
ferent purpose?  The  valuation  of  a  railway  right-of-way  fur- 
nishes a  still  better  case.  Should  a  railroad  company's  real 
estate  accounts  be  revised  to  allow  for  the  appreciation  of  con- 
tiguous property  which  is  used  for  altogether  different  purposes  ? 
Does  the  probable  cost  of  replacement  —  a  purely  hypothetical 
situation  —  have  anything  to  do  with  the  actual  value  of  the 
railway's  land  properties?1  Can  one  reason  from  the  market, 
by  analogy,  to  the  values  of  units  in  use  ? 

^As  a  general  answer  to  these  questions  it  may  be  said  that  the 
market  apparently  represents  the  actual  economic  situation,  and 
as  such  it  furnishes  a  standard'of  value  measurement  which  must 
never  be  lost  sight  of.  The  market  is  always  admitted  to  be  the 
proper  test  when  prices  decline  (price  declines  constitute  a  phase 
of  depreciation)  and  there  is  no  reason  for  supposing  that  it  is 

1  In  rate-making  cases  the  courts  have  sometimes  held  one  way,  sometimes 
another,  on  this  proposition. 


BASIS  FOR  REVALUATION  467 

not  of  importance  as  a  means  of  determining  value  increases. 
In  the  case  of  the  factory  site  mentioned  above  and  in  similar 
problems,  however,  it  should  be  admitted  that  even  the  bona  fide 
values  of  adjoining  tracts  cannot  always  be  considered  a  satis- 
factory test.  If  a  highly  specialized  plant  is  built  upon  the  site, 
the  whole  property  constitutes  an  inseparable  unit.  The  values 
of  plant  and  site  are  joint.  This  situation  may  virtually  remove 
the  site  from  the  land  market  for  years.  If  there  is  no  reasonable 
possibility  that  the  investor  can  take  advantage  of  this  market 
it  virtually  does  not  exist  for  him. 

It  may  be  further  contended,  as  was  noted  in  Chapter  X,  that 
although  appreciation  means  an  increase  in  property  and  conse- 
quently an  increase  in  property  rights,  the  amount  of  this  in- 
crease is  in  no  case  available  for  dividend  appropriations  and 
consequently  should  not  be  recognized.  This  argument  is 
another  phase  of  the  old  idea  that  profits  must  be  available  in 
liquid  assets  in  order  to  be  considered  as  profits.  As  a  matter 
of  fact  the  cash  with  which  to  pay  a  dividend  can  be  secured  on 
short-term  notes  or  otherwise.  Often  corporations  find  it  neces- 
sary to  borrow  for  brief  intervals  to  make  dividend  payments, 
because  dividend  dates  do  not  coincide  with  the  times  at  which 
the  cash  balance  is  large.  Net  revenue  due  to  appreciation  is 
just  as  available  as  is  net  revenue  tied  up  in  any  asset  other  than 
cash.  Net  revenue  once  realized  in  cash  may  not  be  so  available 
at  the  end  of  the  period,  but  may  be  represented  then  by  new 
equipment  and  merchandise.  Even  if  cash  is  available  it  does 
not  always  indicate  a  rational  possibility  of  dividends.  The 
cash  may  be  original  capital,  temporarily  in  liquid  form.  Divi- 
dends depend  primarily  upon  the  showing  of  net  revenue  and 
general  credit  and  financial  conditions,  and  not  upon  the  condi- 
tion of  the  cash  account. 

A  final  objection  —  probably  the  most  significant  —  to  the 
thesis  that  value  changes  in  each  direction  should  be  recognized 
in  the  accounts  is  that  such  a  practice  savors  of  non-conservatism  ; 
it  opens  the  doors,  it  may  be  said,  to  all  sorts  of  inflation ;  it 
enables  the  manager  to  make  any  showing  he  pleases,  etc.  This 
objection  undoubtedly  has  some  force,  but  it  is  hardly  conclusive. 
A  clear  distinction  should  be  made  between  conservatism  and 
downright  concealment.  The  tendency  toward  overstatements 


468  PRINCIPLES  OF  ACCOUNTING 

is  not  necessarily  fostered  by  the  adoption  of  a  consistent  policy 
in  valuations.  Why  should  a  rational  mode  of  thinking  be  ex- 
pected to  lead  to  vicious  practices?  Further  it  must  be  re- 
membered that  there  are  all  sorts  of  ways  of  juggling  accounts, 
in  the  absence  of  governmental  restriction,  without  resorting 
to  an  illegitimate  use  of  appreciation.  Making  inadequate 
depreciation  charges,  charging  repairs  to  capital  and  similar 
practices,  lead  to  overstatement.  Government  regulation  of 
some  kind  is  essential  if  accounts  are  to  be  standardized  and 
illegitimate  practices  prevented.  The  present  illogical  attitude 
of  accountants  (and  of  the  cpurts)  in  regard  to  asset  valuations 
cannot  be  expected  to  do  much  in  the  way  of  promoting  sound 
and  conservative  accounting  practices. 

Consider  this  question  of  conservatism  from  the  standpoint 
of  the  auditor  who  is  preparing  a  balance  sheet  —  the  statement 
of  a  company's  financial  condition.  The  nature  of  this  state- 
ment is  a  matter  of  great  importance.  In  many  cases  directors, 
stockholders,  bondholders,  prospective  investors,  bankers,  credit 
agencies  and  other  interests  see  nothing  but  the  summary  state- 
ments and  base  their  conclusions  upon  these  statements.  To 
serve  these  various  interests  best  how  should  the  balance  sheet 
—  the  most  important^'  financial  statement  —  be  prepared  ? 
There  would  seem  to  be  some  reason  at  least  for  making  the 
balance  sheet  what  is  implied  —  a  correct  statement  of  all  the  assets 
and  equities  in  the  enterprise  as  on  a  given  date.  What  does  the 
investor  wish  to  know  ?  Certainly  he  is  interested  in  the  actual 
status  of  his  investment.  What  does  the  prospective  creditor 
wish  to  know?  Certainly  he  is  interested  in  the  actual  status 
of  the  assets  and  the  distribution  and  extent  of  the  ownership. 
Now  it  is  evident  that  every  misstatement  of  an  asset  means  a 
corresponding  misstatement  of  the  proprietor's  equity  at  least. 
Overstatements  of  assets  by  means  of  fictitious  intangibles,  in- 
adequate depreciation  charges,  maintenance  charged  to  capital, 
the  capitalization  of  discounts  and  losses,  etc.,  have  long  been 
considered  improper  because  of  the  fact  that  everyone  concerned 
is  misled  by  such  practices.  Any  number  of  actual  cases  might 
be  given  to  show  that  such  accounting  procedures  jeopardize 
general  success  and  impair  specific  equities.  Understatement  of 
assets  is  a  hardly  less  reprehensible  practice.  Such  a  practice 


BASIS  FOR  REVALUATION  469 

leads  to  what  are  called  secret  reserves.  The  impropriety  of 
such  accounting  has  also  been  stressed  by  accountants.  The  de- 
frauding of  minority  stockholders  and  income  bondholders,  and 
the  other  questions  of  equity  that  arise  have  been  emphasized 
in  many  recent  works  on  accounting.  The  commendable  out- 
cry against  secret  reserves,  however,  should  be  carried  one  step 
further.  Ignoring  the  appreciation  of  unsold  assets  which  results 
in  an  understatement  of  assets  and  a  corresponding  misstatement 
of  equities  —  is  simply  another  method  of  building  up  secret 
reserves;  and  it  is  essentially  as  misleading  a  practice  as  the 
charging  of  capital  outlays  to  expense. 

To  insist  that  inventories  in  certain  cases  must  be  taken  at  a 
figure  far  below  the  actual  values  in  order  to  prevent  a  general 
overstatement  of  assets  is  from  the  accountant  an  admission  of 
incompetence.  Is  there  any  reason  to  think  that  an  understate- 
ment of  the  materials  inventory  by  $100,000  will  just  offset  over- 
statements in  other  connections?  Why  should  not  each  item  in 
the  trial  balance  be  handled  on  its  merits?  In  making  adjust- 
ments why  should  one  not  be  consistently  conservative  at  all 
points  ?  If  certain  of  the  accounts  receivable  are  doubtful  pare 
the  item  to  the  bone.  If  the  discarded  machinery  in  the  store- 
room has  a  very  dubious  value  put  it  on  at  the  nominal  sum  of  one 
dollar.  But  when  the  actual  present  value  of  an  asset  is  definitely 
known,  is  there  any  reason  for  concealing  a  part  of  the  item  be- 
cause its  present  value  is  above  cost?  Should  the  inventories 
of  actual  assets  whose  values  are  capable  of  almost  exact  deter- 
mination be  understated? 

The  point  was  emphasized  in  Chapter  X  that  the  recognition 
of  appreciation  need  not  obscure  cost  figures.     Special  accounts' 
may  well  be  used  to  represent  any  such  items.     If  it  is  desired) 
such  value  increases  might  be  kept  out  of  the  operating  accounts.  * 
Similarly  in  the  balance  sheet  special  asset  and  surplus  accounts 
may  well  be  used  to  represent  appreciation.     Certainly  if  the 
income  and  balance  sheets  are  prepared  on  the  basis  of  cost 
figures  (or  market  if  market  is  the  lower)  a  supplementary  state- 
ment setting  forth  the  actual  status  of  the  enterprise  should  be  - 
attached.     Accounts  and  statements  which  take  into  account 
all  value  changes  would  surely  seem  to  be  of  more  practical  use  to 
all  parties  concerned  than  records  prepared  on  any  other  basis. 


XXI 

THE  VALUATION  OF  SPECIAL  ASSETS 

WHICHEVER  basis  for  valuation,  cost  or  cost  of  replacement,  is 
decided  upon  in  a  particular  case,  the  physical  inventories  and 
appraisals  must  first  be  taken.  The  units  of  certain  kinds  of 
property  must  be  counted  or  measured.  Estimates'  and 
appraisals  are  necessary  in  the  case  of  complex  assets  such  as 
buildings.  Computations  and  adjustments  are  required  in  the 
valuation  of  rights  such  as  promissory  notes.  The  taking  of 
inventories  is  evidently  not  entirely  an  accounting  problem, 
but  the  accountant  should  be  familiar  with  the  general  rules  to 
be  observed  and  must  be  able  to  decide  in  a  particular  case  as 
to  whether  or  not  sound  principles  are  being  followed.  In  this 
chapter  a  brief  discussion  of  the  valuation  of  particular  assets 
will  be  given. 

CASH   AND   RECEIVABLES 

The  values  of  all  assets  are  measured  in  terms  of  money,  and 
hence,  as  was  explained  in  a  previous  chapter,  the  problem  of 
valuation  really  does  not  arise  in  the  case  of  cash.  In  other 
words  the  trial  balance  cash  figures  are  usually  also  the  balance 
sheet  figures.  If  cash  is  lost  or  stolen  deductions  must  of  course 
be  made;  but  the  physical  inventory  at  any  rate  is  identical 
with  the  value  inventory  since  cash  is  measured  in  terms  of 
itself  as  so  many  dollars  and  cents.  This  statement  assumes, 
however,  that  all  kinds  of  money  in  the  community  are  cir- 
culating freely  at  par  or  face  value.  Where  paper  currency 
becomes  depreciated  it  is  necessary  to  value  such  money  in 
terms  of  the  standard  currency.  In  the  early  days  of  banking 
in  this  country  the  valuation  of  the  bank  notes  in  the  till  was 
about  as  troublesome  a  problem  as  the  valuation  of  a  miscellany 
of  shopworn  goods. 

470 


VALUATION  OF  SPECIAL  ASSETS  471 

Instruments  such  as  personal  checks,  cashiers'  checks  and 
drafts,  postoffice  and  express  money  orders,  etc.,  are  commonly 
treated  as  cash  when  received  or  paid.  Since  such  cash  equiva- 
lents form  a  large  part  of  the  regular  medium  of  exchange  it  is 
legitimate  to  treat  such  items  as  cash,  although  they  are  not 
legal  tender.  Deductions  from  the  face  amounts  due  to  ex- 
change and  taxes,  however,  must  sometimes  be  made.  Further, 
a  particular  check  may  of  course  be  worthless  because  the  drawer 
has  insufficient  funds  on  deposit.  Such  a  situation  is  usually 
discovered  after  the  drawee  has  deposited  the  check  at  his  bank 
and  has  charged  the  item  to  his  cash  account.  In  this  connection 
it  should  be  remembered  that  a  large  part  of  a  firm's  cash  so- 
called  is  simply  a  highly  liquid  account  receivable  against  some 
bank.  Such  a  fund  is  consequently  not  cash  in  the  strictest 
sense  and  is  subject  to  a  small  element  of  risk. 

In  taking  the  cash  inventory  at  the  end  of  the  accounting 
period,  cash  on  hand  must  be  carefully  counted  and  added  to  the 
sum  on  deposit.  Any  cash  equivalents  should  be  carefully 
scrutinized  and  memoranda  which  do  not  represent  cash  at  all 
should  not  be  included.  The  cash  item  as  it  appears  on  the 
balance  sheet  is  often  seriously  inflated  by  the  inclusion  of  ficti- 
tious items.  Generally  cash  is  so  safeguarded  in  the  case  of 
businesses  of  much  size  that  practically  a  perpetual  inventory  of 
cash  is  available. 

Accounts  receivable  are  one  of  the  most  important  kinds  of 
current  assets  in  many  lines  of  business.  Such  accounts  usually 
arise,  as  was  previously  explained,  from  the  sale  of  goods  on 
credit.  In  a  sense  an  account  receivable  is  not  property  at  all 
but  a  claim  to  property.  Such  rights,  however,  are  considered 
as  assets  in  the  accounts,  and  because  of  their  liquid  nature  such 
receivables  are  one  of  the  best  assets  from  the  standpoint  of 
creditors.  From  the  accounting  standpoint  rights  to  property 
constitute  assets  and  this  class  of  assets  includes  a  wide  variety 
of  items.  Securities  of  all  kinds  are  rights.  In  much  the  same 
sense  money  is  not  property  but  only  a  highly  negotiable  claim  to 
commodities  and  services. 

With  hardly  any  exceptions  the  face  of  the  accounts  receivable 
outstanding  at  the  end  of  any  accounting  period  should  be 
depreciated,  as  experience  has  demonstrated  that  not  all  cus- 


472  PRINCIPLES  OF  ACCOUNTING 

tomers  can  be  expected  to  pay  their  accounts.  This  is  partic- 
ularly true  of  the  retail  trade,  but  it  is  also  true  in  other  lines. 
Bankruptcy  is  a  common  occurrence  and  the  creditors  of  in- 
solvent firms  lose  large  sums  on  the  open  book  accounts  involved. 
There  are  two  possible  methods  of  procedure  which  may  be 
followed  in  valuing  accounts  receivable.  Each  account  may  be 
valued  on  its  merits  or  a  certain  per  cent  may  be  deducted  from 
the  outstanding  total.  In  the  first  case  the  size  of  the  account, 
the  length  of  time  it  has  run,  the  financial  prospects  of  the 
customer,  and  similar  factors  would  be  taken  into  consideration  in 
deciding  upon  a  proper  value  for  the  account.  This  detailed 
method  of  inventory  would  be  advisable  in  some  cases,  par- 
ticularly where  a  few  large  accounts  only  were  outstanding. 
Usually,  however,  experience  furnishes  a  test  which  can  be  relied 
upon.  The  merchant  finds,  for  example,  that  on  the  average 
five  per  cent  of  the  face  of  the  accounts  incurred  is  never  paid. 
At  the  end  of  each  accounting  period,  then,  an  amount  equivalent 
to  five  per  cent  of  the  face  of  the  outstanding  accounts  arising 
within  the  past  period  should  be  charged  against  revenue  and 
credited  to  an  appropriate  valuation  account.  The  proper 
entries  for  such  cases  were  shown  in  Chapter  VIII.  In  most  cases 
more  accurate  estimates  of  the  revenue  deduction  can  be  made  in 
this  way  than  would  be  possible  if  each  individual  account  were 
appraised.  If  the  business  is  large  enough  the  amount  of 
worthless  accounts  can  be  as  accurately  estimated  as  can  the 
total  fire  loss  in  the  case  of  a  large  number  of  buildings.  To 
select  the  specific  accounts  which  will  not  be  paid,  however, 
would  be  almost  as  difficult  as  to  pick  out  the  specific  buildings 
which  will  be  burned. 

Items  are  sometimes  included  under  the  head  of  accounts 
receivable  which  have  a  doubtful  character.  Pending  railroad 
claims,  accounts  in  dispute,  withdrawals  by  partners  or  directors 
and  other  questionable  items  are  sometimes  thrown  in  with 
regular  customers'  accounts.  This  is  not  a  desirable  practice. 
In  taking  the  inventory  only  bona  fide  accounts  should  be  treated 
as  receivables.  Assets  which  are  at  best  contingent  in  character 
should  not  be  included,  and  loans  to  owners  themselves  are  a  type 
of  asset  which  should  always  be  isolated. 

As  was  stated  in  another  connection,  interest  usually  does  not 


VALUATION  OF  SPECIAL  ASSETS  473 

explicitly  arise  in  connection  with  book  accounts.  Although 
implicit  interest  may  be  involved  it  would  not  be  desirable  to 
attempt  to  write  down  such  receivables  as  customers'  accounts 
because  they  are  due  in  the  future.  The  intervals  involved  are 
usually  short ;  and  the  theoretical  advantages  arising  from  such 
adjustments  would  be  more  than  offset  by  the  clerical  dis- 
advantages. There  is  some  question,  however,  as  to  the  pro- 
priety of  valuing  accounts  at  their  face  when  cash  discounts 
and  other  deductions  may  be  allowed  at  the  time  of  settlement. 
If  such  potential  discounts  are  large  in  amount  it  might  be 
desirable  to  charge  revenue  with  an  amount  sufficient  to  cover 
the  probable  deductions  and  to  credit  an  appropriate  valuation 
account.  This  is  not  done  as  a  rule,  however,  and  month  by 
month  the  error  does  prove  to  be  a  very  serious  one. 

The  importance  of  making  a  reasonable  allowance  for  doubt- 
ful accounts  at  the  end  of  each  period  and  the  effect  of  such  a 
deduction  upon  the  accounts  and  statements  has  been  sufficiently 
emphasized  in  preceding  chapters. 

Promissory  notes  and  similar  receivables  are  also  subject  to 
depreciation.  The  accrued  deduction  may  be  estimated  in  much 
the  same  way  as  was  just  explained  for  accounts  receivable. 
The  payment  of  a  note,  however,  is  somewhat  more  easily  en- 
forced than  that  of  an  account  and  hence  the  rate  of  depreciation 
is  not  as  high  as  in  the  case  of  open  accounts.  A  note  is  a  written 
promise  to  pay,  and  hence  is  a  prima  facie  evidence  of  indebted- 
ness. An  account  is  only  a  tacit  promise,  and  it  is  often  diffi- 
cult to  produce  satisfactory  evidence  of  indebtedness.  The 
value  of  a  note  depends,  naturally,  upon  the  integrity  of  the 
maker  and  general  financial  conditions. 

In  the  case  of  notes  the  due  date  is  definitely  known  and  the 
rate  of  interest  involved  is  either  expressly  stated  or  it  can  be 
exactly  determined.  In  the  case  of  interest  bearing  notes  the 
accrued  interest  is  set  up  as  an  independent  asset.  In  the  case 
of  non-interest  bearing  notes  the  interest  accrual  increases  the 
discounted  value.  The  process  of  taking  inventories  of  such 
securities  on  a  mathematical  basis  was  fully  discussed  in  Part 
Three. 

It  may  be  assumed  that  the  market  for  accounts  and  notes 
is  so  imperfect  and  restricted  that  the  question  as  to  the  proper 


474  PRINCIPLES  OF  ACCOUNTING 

basis  for  valuation  does  not  arise.  As  a  matter  of  fact  notes  are 
often  highly  negotiable,  and  changes  in  the  rate  of  interest 
actually  affect  the  values  of  such  assets. 


MERCHANDISE  AND   GOODS  IN  PROCESS 

Merchandise  and  finished  goods,  materials,  supplies,  and  goods 
in  process  furnish  much  more  difficult  problems  of  valuation 
than  arise  in  the  case  of  the  receivables.  The  first  question  to 
be  considered  in  connection  with  the  valuation  of  such  current 
and  working  assets  is  the  treatment  of  the  various  items  which 
make  up  the  total  cost. 

The  retailer,  for  example,  buys  a  shipment  of  merchandise. 
The  invoice  price  is  $i  ,000.  This  price,  however,  does  not  include 
the  freight  which  the  buyer,  it  will  be  assumed,  must1  pay.  It 
does  not  include  the  cost  of  drayage,  the  cost  of  uncrating  and 
unpacking,  or  the  expense  of  shelving  and  otherwise  preparing 
goods  for  sale.  The  value  of  the  merchandise  on  the  shelves, 
evidently,  is  the  sum  of  all  of  these  items,  $1,200,  it  may  be 
assumed. 

The  merchant  sometimes  neglects  this  analysis  and  charges 
the  additional  costs  to  expense  as  they  are  incurred.  Unless 
the  inventory  at  the  end  of  the  period,  however,  includes  a  proper 
percentage  of  such  costs,  the  value  of  merchandise  on  hand  will 
be  understated  and  net  revenue  will  be  correspondingly  mis- 
stated. One  method  of  making  the  necessary  adjustment  in 
such  cases  was  explained  in  Chapter  VIII.  The  theoretically 
exact  procedure  would  be  to  charge  the  merchandise  or  materials 
accounts  with  such  additional  expenditures  as  they  are  incurred. 
If  this  is  not  feasible  because  of  the  fact  that  the  amount  of 
operating  outlays  such  as  labor  and  other  costs  applicable  to  the 
asset  accounts  cannot  be  conveniently  determined  day  by  day, 
the  division  of  charges  might  be  made  at  the  end  of  the  period. 
At  that  time  the  proper  proportion  of  the  debit  balance  of  the 
Wages  account,  for  example,  could  be  credited  to  that  account 
and  charged  to  Merchandise  Inventory.  The  balance  of  the 
Wages  account  would  then  be  closed  into  Expense  and  Revenue. 
Whatever  accounting  procedure  is  adopted  the  inventory  of 


VALUATION  OF  SPECIAL  ASSETS  475 

merchandise  should  certainly  not  be  understated  by  the  omission 
of  legitimate  costs. 

This  problem  of  cost  allocation  arises  still  more  emphatically 
in  factory  accounting  in  the  case  of  goods  in  process  and  finished 
goods,  as  was  stated  in  Chapter  VIII.  Goods  in  Process  must 
not  be  inventoried  simply  on  the  basis  of  the  value  of  the 
materials  used.  A  proper  percentage  of  all  the  costs  of  operating 
the  plant  should  be  included  in  the  inventory.  Finished  goods 
should  be  valued  on  the  basis  of  an  apportionment  of  all  the 
costs  with  the  exception  of  those  expenses  peculiarly  incident  to 
the  selling  end  of  the  business.  If  the  entire  business  process 
from  the  purchase  of  raw  material  to  the  delivery  of  the  finished 
product  were  considered  as  a  single  process,  the  total  cost  in- 
curred, including  selling  and  administrative  expenses,  might  be 
divided  in  some  arbitrary  way  between  the  manufacturing  and 
selling  phases  of  the  business.  A  certain  per  cent  of  the  total 
might  then  be  included  in  the  finished  goods  inventory. 

The  taking  of  inventories  of  goods  in  process  and  finished  goods 
is  essentially  a  part  of  the  general  problem  of  cost  accounting. 
This  is  not  the  place  to  go  into  a  detailed  discussion  of  cost 
methods,  but  the  above  statement  should  enable  the  student  to 
recognize  the  significance  of  cost  accruals  in  valuations. 

Since  the  prices  of  such  assets  as  materials  and  merchandise 
are  subject  to  market  fluctuations  the  question  arises  as  to 
whether  cost  or  cost  of  replacement  is  the  proper  basis  for 
valuations.  In  any  case  an  inventory  must  be  taken  to  deter- 
mine the  number  of  units  on  hand,  but  in  finding  the  value 
inventory  a  decision  must  be  made  as  to  the  proper  price  per 
unit  to  apply  to  the  physical  inventory.  In  general  accountants 
adhere  to  the  rule  that  cost  prices  should  be  used  unless  market 
prices  are  lower,  in  which  case  market  prices  should  be  used. 
This  rule  is  evidently  not  in  agreement  with  the  general  view 
developed  in  the  preceding  chapter ;  and  it  would  require  some 
very  important  practical  considerations  to  justify  such  an  illogical 
procedure.  Why  should  the  cost  of  replacement  or  market 
price  be  the  proper  basis  for  valuation  in  one  case  and  not  in 
the  other?  What  considerations  justify  a  shifting  from  one 
basis  to  another? 

The  rule  adopted  is  evidently  conservative  in  that  the  lower 


476  PRINCIPLES  OF  ACCOUNTING 

of  the  two  important  figures  is  always  taken  and  it  is  usually 
justified  on  this  ground.  As  a  matter  of  fact  such  a  principle 
of  valuation  does  not  insure  conservatism.  Conservatism  is 
enforced  only  by  sound  reasoning,  integrity,  and  governmental 
regulation.  As  has  been  pointed  out  by  several  writers  a  manager 
interested  in  making  a  favorable  showing  might  easily  use  an 
illegitimate  cost  figure  in  taking  the  inventory.  A  small  ship- 
ment might  be  purchased  at  an  unreasonable  price  and  this 
figure  might  be  applied  to  the  entire  inventory.  Unless  cost 
prices  are  on  a  strictly  competitive  basis  inventories  at  cost 
may  be  inflated.  Similarly  in  using  cost  of  replacement  as  a 
basis  for  valuation  an  illegitimate  figure  may  be  used.  In 
other  words,  whichever  basis  for  valuation  is  nominally  adopted, 
it  is  possible  for  a  careless  or  dishonest  manager  to  inflate 
inventories. 

The  above  statement  that  a  manager  may  take  an  unduly 
high  cost  figure  and  apply  it  to  all  goods  on  hand  suggests  one 
of  the  most  serious  difficulties  facing  the  accountant  who  insists 
upon  cost  or  market,  whichever  is  the  lower,  as  the  proper  basis 
for  inventories.  In  a  changing  market  the  goods  on  hand  will 
usually  have  been  purchased  in  several  lots  at  several  different 
cost  prices.  Suppose  that  all  of  these  cost  figures  are  below  the 
present  market  price.  How  is  the  inventory  to  be  computed? 
It  is  usually  said  that  a  weighted  average  cost  should  be  used. 
This  rule,  however,  only  apparently  avoids  the  logical  difficulty 
of  setting  several  prices  upon  similar  units  in  the  same  situation. 
This  may  be  shown  by  an  illustration. 

Suppose  that  a  coal  dealer  is  taking  an  inventory  of  coal  on 
hand.  During  the  past  period  he  has  purchased  three  shipments 
of  a  particular  kind  of  coal  at  $4,  $5,  and  $6  per  ton  respectively. 
There  is  now  on  hand  1000  tons  of  each  shipment.  The  average 
unit  cost  is  evidently  $5  per  ton.  On  the  basis  of  this  figure  the 
inventory  amounts  to  $15,000.  This,  however,  is  exactly  the 
same  figure  that  is  obtained  by  valuing  the  three  lots  of  1000 
tons  each  at  $4,  $5,  and  $6  respectively  and  adding  the  totals. 
In  other  words,  the  use  of  the  average  unit  cost  in  taking  inven- 
tories gives  exactly  the  same  results  as  the  valuation  of  each  lot 
on  hand  at  its  actual  cost.  If  cost  rather  than  cost  of  replace- 
ment is  used  as  a  basis  for  such  valuations  there  is  no  way  of 


VALUATION  OF  SPECIAL  ASSETS  477 

avoiding  a  rather  ridiculous  violation  of  the  law  of  single  price. 
If  this  illogical  procedure  is  adopted,  there  is  evidently  no  advan- 
tage to  be  gained  from  the  determination  of  an  average  unit  cost 
as  far  as  the  taking  of  the  inventory  is  concerned.  Each  lot 
may  be  valued  on  the  basis  of  its  actual  cost  without  further 
computation.1 

The  discussion  of  the  valuation  of  merchandise  and  materials 
has  thus  far  ignored  the  question  of  possible  depreciation  due  to 
shopwear  or  other  deterioration,  and  to  obsolescence.  Such 
depreciation,  however,  is  a  serious  possibility.  The  management 
is  often  reluctant  to  admit  that  such  value  declines  have  occurred, 
but  an  important  cost  in  many  lines  of  business  is  due  to  deprecia- 
tion from  these  causes.  Adequate  deductions  from  revenue 
should  be  made  to  cover  such  expirations.  It  is  exceedingly 
difficult  to  accurately  estimate  these  changes,  and  in  view  of 
this  fact  the  allowance  should  be  liberal.  The  concurrent  credit 
entries  may  be  listed  in  the  merchandise  accounts  or  in  an 
appropriate  valuation  account. 

As  was  explained  in  a  preceding  chapter  it  is  customary  to 
enter  merchandise  and  similar  assets  in  the  accounts  at  the  gross 
invoice  price.  When  discounts  are  taken  the  amount  of  such 
allowances  virtually  constitutes  a  deduction  from  the  cost  of  goods 
purchased.  A  question  arises  as  to  whether  in  taking  the  inven- 
tory any  deductions  should  be  made  from  the  value  of  goods  on 
hand  to  cover  possible  discounts.  If  the  amount  of  the  possible 
discounts  is  large  some  deduction  on  this  account  should  doubt- 
less be  made.  Usually  this  adjustment  is  ignored  and  although 
this  procedure  is  incorrect  the  amount  of  the  error  month  by 
month  is  small. 


MACHINERY,    BUILDINGS,    AND   LAND 

Fixed  tangible  assets  such  as  buildings  and  machinery  furnish 
difficult  problems  in  valuations.  Such  assets  are  purchased  by  a 
business  to  be  used  in  operation  and  not  to  be  resold  as  is  mer- 
chandise ;  nor  do  they  become  physically  embodied  in  the  final 
product  as  do  raw  materials.  As  was  admitted  in  the  preceding 

1  This  discussion  is  not  intended  to  imply  that  an  average  of  prices  is  not  a 
useful  figure  in  connection  with  inventories  and  purchases. 


478  PRINCIPLES  OF  ACCOUNTING 

chapter,  cost  less  depreciation  due  to  causes  the  effect  of  which 
can  be  calculated  with  a  reasonable  degree  of  accuracy  is  a 
fairly  satisfactory  basis  for  the  valuation  of  such  assets.  Espe- 
cially is  this  true  as  long  as  advancing  costs  of  construction  do 
not  offset  depreciation  entirely.  An  enterprise  in  buying  a  fixed 
asset  such  as  a  building  has  thereby  committed  itself  to  a  definite 
policy.  Within  certain  limits  changes  in  the  prices  of  labor 
and  materials  do  not  affect  the  value  of  the  individual  specialized 
structure.  As  far  as  the  particular  business  is  concerned,  such 
changes  may  have  no  immediate  effect  upon  the  price  of  its 
product ;  and  the  owners  are  not  in  a  position  to  act  upon  the 
apparent  changing  capital  cost  and  convert  their  capital  to  an- 
other use.  Only  as  the  building  becomes  unfit  for  use  through 
operation  —  unless  conditions  change  very  decidedly  —  can  the 
capital  fund  involved  be  withdrawn.  In  other  words,  it  is  some- 
what doubtful  if  market  prices  can  be  said  to  affect  the  values  of 
fixed  assets  in  use  in  any  definite  fashion. 

The  recognition  of  appreciation  due  to  changing  construction 
costs  in  connection  with  fixed  assets  is  then  not  as  important 
as  in  the  case  of  current  assets  already  discussed.  The  changing 
market  prices  of  materials  and  merchandise  usually  are  reflected 
almost  immediately  in  the  price  of  the  product.  The  appre- 
ciation of  such  current  assets  is  therefore  a  fact  of  immediate 
significance.  In  the  case  of  assets  such  as  securities  the  market 
price  may  be  identical  with  the  value  of  securities  held  without 
any  question,  as  was  explained  in  Chapter  XVIII.1  On  the 
other  hand  it  should  be  recognized  that  serious  changes  in 
construction  costs  do  affect  the  values  of  such  assets  as  machinery 
and  buildings  in  the  long  run;  and  such  changes  must  be  rec- 
ognized by  the  management  if  the  capital  of  the  investor  is  to 
be  used  to  the  best  advantage.  It  may  be  highly  profitable, 
for  example,  to  remodel  an  almost  new  building  so  that  it  may 
be  possible  to  shift  from  the  production  of  one  commodity  to 
another  even  if  the  price  of  the  old  product  is  high  enough  to 
yield  a  fair  return  on  the  original  cost  of  the  plant. 

While  in  principle,  then,  it  may  be  said  that  market  changes 
affect  the  values  of  fixed  and  current  assets  alike,  it  may  be 

1  The  regulations  governing  banking  companies,    for  example,  usually  re- 
quire such  institutions  to  value  their  securities  at  the  market. 


VALUATION  OF   SPECIAL  ASSETS  479 

expedient  to  ignore  minor  fluctuations  in  the  construction  costs  of 
fixed  assets  for  a  period  of  years.  A  serious  price  movement  in 
either  direction,  however,  should  be  recognized.  At  least  the 
management  must  be  cognizant  of  such  a  change  if  wise  decisions 
in  regard  to  replacements  and  reconstruction  are  to  be  made. 
Further,  in  order  to  present  the  correct  status  of  the  investment 
in  the  balance  sheet  a  significant  depreciation  or  appreciation 
due  to  price  changes  should  be  recognized  in  the  accounts. 

The  problem  of  cost  allocation  also  arises  in  connection  with 
the  valuation  of  fixed  assets.  The  value  of  a  machine  purchased 
and  installed,  for  example,  includes  the  invoice  price,  trans- 
portation charges,  and  installation  costs.  If  a  company  con- 
structs its  own  plant  and  equipment  it  may  be  necessary  to  set 
up  some  special  asset  accounts  which  represent  the  amount  of 
expenditures  applicable  to  the  property  as  a  whole  but  not  to 
individual  asset  accounts  as  was  explained  in  Chapter  XIX. 
Wherever  costs  can  be  accurately  allocated,  however,  they  should 
be  apportioned  among  the  plant  and  equipment  accounts. 

A  question  sometimes  arises  as  to  the  valuation  of  a  single 
property  unit  constructed  by  an  operating  company  for  its  own 
use.  Suppose,  for  example,  that  a  manufacturing  company 
constructs  a  power  unit  at  an  actual  cost  of  $15,000,  and  that 
this  same  unit,  purchased  on  the  market  and  installed  would 
cost  $15,500.  Which  amount  should  appear  in  the  company's 
property  accounts?  This  is  essentially  the  problem  of  interest 
during  construction  already  rather  fully  discussed.  The  con- 
clusions reached  in  Chapter  XIX  can  be  applied  to  this  case. 
The  proper  asset  charge  is  $15,000.  There  is  no  good  reason 
why  the  company  should  capitalize  its  own  service  and  accord- 
ingly accrue  interest  and  other  phases  of  income  on  this  asset. 
The  company  is  a  constructing  as  well  as  an  operating  company. 
The  rate  of  return  it  secures  is  larger  during  the  period  of  opera- 
tion than  would  be  the  case  if  the  asset  had  been  constructed 
by  an  outside  company.  It  is  the  function  of  the  property 
accounts  to  show  the  actual  investment  of  the  owners,  not  the 
amount  which  the  investment  would  have  been  if  the  property 
had  been  purchased  elsewhere.  To  increase  the  value  of  the 
property  by  accruing  interest  on  the  actual  investment  not  only 
means  the  recognition  of  revenue  before  there  is  good  evidence 


480  PRINCIPLES  OF  ACCOUNTING 

that  revenue  has  accrued,  but  it  also  alters  the  rate  of  return 
finally  realized  in  such  a  way  as  to  obscure  the  realities  of  the 
case. 

On  the  other  hand,  it  is  important  that  all  costs  actually 
incurred  in  the  construction  of  the  property  unit  mentioned 
above  should  be  charged  to  the  property  account.  The  value 
of  all  the  materials  furnished  and  labor  utilized  is  a  capital  charge. 
Further,  a  portion  of  the  ordinary  expenses  involved  in  running 
the  regular  power  plant  which  furnishes  the  necessary  power  for 
construction  operations,  as  well  as  a  portion  of  the  depreciation 
of  the  power  plant,  should  be  credited  to  the  regular  expense 
accounts  and  charged  to  the  new  property  account.  That  part 
of  the  total  expense  of  operating  the  plant  which  is  allocatable  to 
the  construction  of  the  new  unit  should  be  charged  to  property. 
If  all  of  these  costs  are  determined  and  charged  to  property  the 
difference  between  the  construction  cost  of  the  finished  unit 
and  its  market  price  should  approximately  equal  the  profit  of  the 
ordinary  construction  company.  An  operating  company,  evi- 
dently, will  not  construct  its  own  equipment  unless  there  is  some 
such  difference. 

The  depreciation  of  such  assets  as  buildings  and  machinery 
may  be  determined  by  actual  appraisals  at  the  end  of  each 
accounting  period,  or  these  charges  may  be  determined  in  ad- 
vance by  setting  up  a  schedule  which  apportions  total  cost 
over  the  estimated  service  life.  In  the  next  two  chapters  the 
problems  of  depreciation  accounting  will  be  fully  discussed. 

The  distinction  between  maintenance  and  improvement  of 
plant  and  equipment  is  not  always  easily  made,  as  was  explained 
in  Chapter  X,  for  the  actual  circumstances  of  each  case  must  be 
investigated  in  coming  to  a  proper  decision.  Unless  a  particular 
charge  is  quite  evidently  a  value  improvement  it  is  a  conservative 
policy  to  consider  the  item  a  repair.  The  accounting  for  repairs 
and  renewals  will  be  discussed  in  the  next  chapter. 

Land  values  are  often  left  on  the  books  for  long  periods  with- 
out change.  This  practice  is  in  general  justifiable  unless  very 
serious  changes  in  the  value  of  contiguous  property  occur. 
It  is  particularly  true  of  land  properties  that  the  capital  in- 
volved cannot  be  withdrawn  readily  in  response  to  market 
changes.  Hence  there  is  some  question  as  to  the  importance 


VALUATION  OF  SPECIAL  ASSETS  481 

of  the  market.  As  was  explained  in  the  preceding  chapter  a 
tract  of  land  which  is  the  site  of  an  expensive  plant  is  almost 
inevitably  connected  with  a  particular  line  of  production  for 
years.  It  can  hardly  be  said,  therefore,  that  market  changes 
actually  affect  its  value  except  in  the  long  run.  Fluctuations  in 
land  values  may  then  be  safely  ignored  unless  the  change  becomes 
so  serious  as  to  make  it  possible  or  expedient  to  change  a  business 
policy. 

This  statement  is  only  true  in  the  case  of  factory  sites,  railway 
rights-of-way,  and  similar  tracts.  The  values  of  lands  which  are 
held  by  realty  and  development  companies,  and  of  timber  tracts, 
mining  properties,  residence  lots,  etc.,  are  affected  directly  by 
market  conditions,  and  to  ignore  price  changes  in  such  cases  is  a 
somewhat  questionable  procedure. 

Lands  may  be  acquired  by  cash  payment  (or  an  equivalent) 
or  by  the  issue  of  securities.  It  was  stated  in  a  preceding 
chapter  that  in  such  cases  the  property  account  is  often  charged 
with  the  par  of  the  securities  issued,  though  such  transactions 
lead  to  large  inflations  in  the  asset  accounts  since  securities  are 
often  issued  at  a  discount  and  the  par  value  in  such  a  case  may 
bear  little  relation  to  the  actual  cost  of  the  property.  The 
property  accounts  of  corporations,  accordingly,  often  show  over- 
stated land  values. 

The  valuation  of  fixed  assets  such  as  securities  was  sufficiently 
discussed  in  Chapter  XVIII.  The  fixed  intangibles  and  their 
valuation  will  be  considered  in  Chapter  XXIV.  Deferred 
assets,  such  as  prepaid  insurance  and  similar  rights  to  services, 
present  no  very  difficult  problems  of  valuation.  The  treatment  of 
such  assets  was  briefly  considered  in  Chapter  X. 


21 


XXII 

THE  DEPRECIATION  ACCOUNTS 

THE  revaluation  of  assets  for  balance  sheet  purposes,  as  has 
already  been  suggested,  presents  many  complex  problems. 
Particularly  is  this  true  of  the  fixed  tangible  assets  which  are 
used  for  a  rather  long  period  of  years  and  which  must  have 
frequent  repairs  to  maintain  them  in  a  condition  suitable  for 
efficient  operation.  Between  the  date  such  an  asset  as  a  piece 
of  machinery  is  purchased  and  the  date  that  it  is  sold  for  scrap 
or  junk,  for  instance,  there  are  no  market  tests  obtainable  for 
inventory  purposes,  and  yet  valuations  must  be  made  if  the 
balance  sheet  is  to  be  of  service  as  a  statement  of  condition  or 
the  expense  and  revenue  sheet  as  a  correct  statement  of  operating 
results  for  each  accounting  period.  It  is  the  purpose  of  this 
chapter  to  raise  some  of  the  questions  in  this  connection  and  to 
explain  the  nature  of  the  accounts  commonly  used  for  recording 
the  data  concerning  maintenance  and  depreciation. 

THE  DEPRECIATION  PROBLEM 

It  might  be  well  at  the  outset  of  this  discussion  to  explain  in 
brief  why  the  problems  of  maintenance  and  depreciation  are 
commonly  restricted  to  the  fixed  asset  group  of  accounts.  An 
important  characteristic  of  the  current  assets,  particularly  the 
current  tangibles,  is  that  units  of  such  property  are  completely 
consumed  in  giving  off  a  single  service.  Consequently  the 
amount  of  such  property  consumed  may  be  easily  measured. 
Thus  the  number  of  pounds  or  tons  of  coal  consumed  may  be 
determined  by  physical  measurement,  and  the  value  expiration 
may  be  obtained  by  multiplying  this  figure  by  the  cost  per  unit.1 

1  To  bring  out  the  essentials  of  depreciation  accounting  it  has  seemed  best  to 
ignore,  for  the  most  part,  the  problem  of  price  changes, 

482 


THE  DEPRECIATION  ACCOUNTS  483 

Similarly  the  amount  of  raw  materials  or  merchandise  consumed 
may  be  determined  by  inspection  (counting,  weighing,  measuring, 
etc.)  and  this  amount  multiplied  by  the  cost  per  unit  will  give 
the  value  expiration.  In  case  records  of  quantity  consumed 
are  not  kept,  the  same  information  can  be  (and  often  is)  obtained 
by  the  inventory  process.  The  quantity  on  hand  is  measured 
physically,  multiplied  by  the  price  per  unit  to  find  the  value 
on  hand,  and  then  the  value  expiration'  is  found  by  deducting 
the  value  on  hand  from  the  net  charge  for  item  purchased.  The 
important  point  to  be  made  is  that  a  market  price  can  be  applied 
to  single  units  and  that  a  unit  of  this  type  is  either  completely 
consumed  or  not  used  at  all. 

The  value  expiration  of  current  intangibles  such  as  the  services 
of  advertising,  insurance,  etc.,  and  outside  claims  such  as  notes 
and  accounts  receivable,  may  likewise  be  measured  with  ease 
although  the  physical  units  are  not  available.  Such  assets 
remain  in  the  possession  of  the  business  for  such  short  periods 
that  inventory  figures  (and  consequently  the  expense  figures) 
can  be  readily  stated.  The  market  again  is  available  for  test- 
ing the  accuracy  of  the  data  used  in  the  computation. 

Moreover  current  assets  are  for  the  most  part  consumed  in 
the  accounting  period  during  which  the  purchases  are  made. 
The  retail  merchant  attempts  to  "turn"  his  stock  several  times 
during  the  year  and  hence  keeps  as  small  a  stock  on  hand  at 
any  one  time  as  possible.  The  manufacturer  often  maintains 
a  stock  of  raw  materials  on  hand  just  sufficient  to  keep  the 
plant  running  from  week  to  week,  and  at  the  close  of  any 
accounting  period  there  remains  on  hand  so  small  a  propor- 
tion of  the  total  purchases  of  such  items  that  the  amount 
involved  in  the  inventory  is  relatively  small. 

Contrast  this  situation  with  the  fixed  assets.  In  the  first  place 
a  fixed  asset  remains  intact,  as  a  unit,  over  many  accounting  ' 
periods.  Such  a  tangible  asset  as  a  building,  for  example,  which 
costs  $10,000  may  last  for  twenty  years,  the  complete  building, 
as  a  unit,  remaining  in  existence  and  performing  its  service 
throughout  the  whole  period.  The  amount  of  $10,000  is  an 
expense  of  a  twenty-year  period  but  the  proportion  of  this  expense 
for  each  year,  or  other  accounting  period,  is  desired.  Physical 
measurement,  obviously,  cannot  be  relied  upon  to  furnish  a 


484  PRINCIPLES  OF  ACCOUNTING 

basis  for  value  expiration.  The  building  is  essentially  the  same 
in  size,  shape,  number  of  rooms,  etc.,  on  the  day  of  abandonment 
as  on  the  day  of  acquisition.  Its  condition,  however,  has 
deteriorated ;  the  foundation  has  decayed,  the  roof  needs 
replacing,  the  walls  are  weakened,  but  it  is  complete  until  the 
day  it  is  retired  from  service.  The  value  gradually  expires 
throughout  the  twenty  years,  however,  and  it  is  the  purpose  of  the 
depreciation  accounts  to  record  the  value  change  currently. 
Depreciation  may  be  denned  as  the  value  expiration  of  fixed 
property  items. 

As  physical  measurement  cannot  be  used  for  determining  the 
depreciation  charge  in  the  case  of  long-lived  property  items, 
other  types  of  computation  must  be  relied  upon.  In  the  case  of 
long-term  securities  the  accountant  has  recourse  to  amortization 
and  annuity  schedules,  interest  tables  and  formulae,  and  market 
quotations.  This  form  of  investment,  however,  presents  such 
specialized  problems  that  a  separate  chapter  has  been  devoted 
to  the  valuation  of  these  assets.  Further  the  downward  trend  of 
value  changes  in  securities  is  not  usually  spoken  of  as  depreciation 
although  it  is  of  this  general  character.  Fixed  tangible  and 
certain  Intangible  assets,  however,  present  a  different  case. 

The  depreciation  problem  as  discussed  in  this  text  is  for  con- 
venience divided  into  two  main  parts.  The  present  chapter  is 
devoted  to  a  presentation  of  the  different  methods  for  recording 
depreciation;  and  a  discussion  of  the  methods  of  measuring 
depreciation  is  deferred  to  the  next  chapter. 

One  further  problem  of  depreciation  which  is  of  considerable 
practical  importance  is  concerned  with  the  amount  which  should 
be  deducted  from  the  inventory  of  the  fixed  assets  of  a  public 
utility  hi  order  to  cover  depreciation.  The  courts  have  held 
that  the  proper  base  for  determining  a  reasonable  rate  is  the 
original  cost,  or  the  cost  of  reproduction  minus  accrued  deprecia- 
tion, but  the  advisability  of  this  policy  is  often  questioned  by 
accountants  and  engineers.  It  is  said  that  the  method  of 
accounting  for  depreciation  should  be  considered  before  deter- 
mining whether  or  not  any  deduction  should  be  made  for  depre- 
ciation and  if  so  the  amount  to  be  so  deducted.  This  is  much 
more  than  an  accounting  question,  however,  and  it  will  not  be 
taken  up  in  detail.  It  is  simply  mentioned  here  to  emphasize 


THE  DEPRECIATION  ACCOUNTS  485 

* 

the  importance  of  the  accounting  phases  of  the  problem.  Some 
light  will  be  shed  on  the  question  as  the  discussion  proceeds 
through  both  of  the  chapters. 


REPAIRS   AND   RENEWALS 

Numerous  expenditures  for  repairs  must  be  made  on  the 
ordinary  fixed  physical  property  item  in  order  to  keep  the  prop- 
erty in  condition  for  service.  The  total  cost  of  the  property 
may  therefore  be  considered  to  be  the  original  purchase  price, 
or  construction  cost,  plus  all  expenditures  for  repairs.  The  total 
depreciation  of  the  item  is  the  difference  between  the  total  cost 
and  the  salvage  value  at  the  end  of  its  service  life.  It  is  custom- 
ary, however,  to  treat  this  maintenance  cost  in  two  parts ; 
namely,  repairs  and  renewals.  A  repair  is  a  replacement  of  a 
part  of  a  unit,  a  renewal  is  a  replacement  of  the  whole  unit. 
This  is  a  rather  arbitrary  distinction  but  is  convenient  for  use  in 
the  accounting  records.  The  unit  is  the  completed  property 
item  as  represented  in  the  purchase  price  or  construction  records 
at  the  date  of  acquisition.  Thus  the  unit  of  equipment  of  a 
railroad  is  the  locomotive,  the  car,  the  vessel,  etc.,  though  a  unit 
as  used  in  the  accounts  may  differ  from  the  unit  of  the  operating 
official,  who  looks  upon  the  locomotive,  for  example,  as  made  up 
of  a  number  of  structural  parts  such  as  boiler,  drivers,  wheels, 
etc.,  any  one  of  which  could  be  considered  as  a  unit  for  certain 
purposes.  Whenever  a  replacement  of  a  worn-out  part  is  made 
it  is  considered  as  a  repair,  and  in  the  technical  sense  only  the 
replacement  of  the  whole  accounting  unit  constitutes  a  renewal. 

A  repair  is  made  for  the  purpose  of  making  good  a  decrease 
in  the  efficiency  of  a  unit  through  use.  If  the  unit  taken  for 
accounting  purposes  in  each  case  were  sufficiently  large,  all 
expenditures  to  replace  property  items  would  be  repairs.  Usually 
the  unit  as  accepted  is  restricted  to  an  asset  of  such  size  that  this 
condition  could  not  obtain.  It  is  usually  assumed  that  a  repair 
makes  good  depreciation  which  occurs  in  the  accounting  period 
during  which  the  repair  is  made,  but  in  the  ordinary  case  the 
repair  charge  cannot  take  care  of  all  of  the  depreciation  for  it  is 
evident  that  at  some  date  the  entire  unit  must  be  renewed.  As 
one  author  very  aptly  puts  the  case,  "All  machinery  is  on  an 


486  PRINCIPLES  OF  ACCOUNTING 

X 

irresistible  march  to  the  junk  heap,  and  its  progress,  while  it 
may  be  delayed,  cannot  be  prevented  by  repairs."  l 

A  property  unit  may  become  worn  out  or  decayed  to  such  an 
extent  that  the  cost  of  repairing  the  unit  would  be  so  great  that 
it  would  be  more  practical  to  abandon  the  item  and  purchase 
an  entirely  new  unit.  Indeed  one  of  the  functions  of  the 
manager  is  to  estimate  carefully  or  compute  the  comparative 
expenses  incident  to  the  two  choices  of  action.  Shall  the 
machine  be  repaired  and  operated  for  another  year  or  shall  it 
be  abandoned  and  a  new  one  purchased?  The  time  must 
arrive  when  the  latter  procedure  is  the  more  economical. 
Further,  an  item  of  property  which  is  still  in  good  physical 
condition  for  performing  the  service  for  which  it  was  purchased, 
may  become  worthless  through  inadequacy  or  obsolescence. 
Thus  a  railroad  bridge  may  be  rendered  inadequate  for  use  with 
an  increased  traffic  or  because  a  change  in  the  type  of  commodities 
carried  necessitates  heavier  locomotives;  or  a  newly  invented 
piece  of  machinery  may  replace  an  older  type  which  is  still  in 
good  condition  but  is  not  capable  of  producing  the  service  as 
efficiently  as  the  improved  type. 

The  depreciation  made  good  by  repairs  —  as  stated  above  — 
is  usually  treated  as  distinct  from  that  made  good  by  renewals. 
In  fact  the  former  is  usually  spoken  of  as  maintenance  to  dis- 
tinguish the  character  of  the  charge  from  depreciation.  This 
terminology  may  seem  somewhat  illogical,  based  as  it  ultimately 
is  on  the  arbitrary  definition  of  the  unit,  but  it  has  certain 
practical  advantages.  Obviously,  it  would  be  inadvisable,  if 
not  absolutely  impossible,  to  treat  each  small  expenditure  as  a 
renewal.  To  make  an  extreme  illustration,  there  is  considerable 
difference  between  the  replacement  of  a  bolt  costing  perhaps  five 
cents  on  an  auto  truck  and  the  replacement  of  the  truck  itself. 
There  are  surely  certain  practical  reasons  for  accounting  for  the 
two  expenditures  on  different  bases.  It  must  be  admitted  that 
the  choice  of  the  unit  often  results  in  calling  certain  replacements 
repairs  which  might  better  be  called  renewals,  but  the  line  of 
differentiation  is  a  good  one. 

The   entries   for  recording  repair  charges  are  very  simple. 
The  Repair  Expense  account  is  charged  and  Cash,  or  the  prop- 
1  Hatfield,  Modern  Accounting. 


THE  DEPRECIATION  ACCOUNTS  487 

erty  account  representing  other  assets  used  in  making  the 
repair,  is  credited.  Thus  if  a  piece  of  machinery  is  overhauled 
at  a  cost  of  $500,  the  following  entries  are  made, 

Repair  Expense $500 

Cash $500 

A  classification  of  repair  expense  accounts  is  desirable  to  show  the 
cost  of  repairing  different  kinds  of  property  items.  A  different 
repair  account  for  each  class  of  property  used  is  desirable.  In 
a  large  enterprise  a  complete  organization  is  maintained  for 
doing  repair  work.  The  repair  expenses  in  such  cases  can 
be  used  for  measuring  in  some  degree  the  efficiency  of  the  mainte- 
nance department.  The  repair  accounts  again  may  be  further 
subdivided  to  show  the  cost  of  the  different  elements  entering  into 
the  repair  work  such  as  labor,  materials,  power,  etc.  A  classifi- 
cation of  maintenance  accounts  for  administrative  purposes  is 
often  desired  and  may  be  incorporated  in  a  detailed  income 
sheet.  The  point  to  be  emphasized  is  that  the  cost  of  the 
repair  is  charged  to  the  expense  accounts  of  the  period  in  which 
the  repair  is  made. 

The  renewal  of  a  property  item  occurs  when  the  old  item  is 
taken  from  service.  The  item  may  be  replaced  with  like  prop- 
erty or  with  an  entirely  different  type.  A  renewal  does  not 
necessarily  involve  a  replacement  of  a  new  unit  for  an  old ;  the 
fact  that  an  old  item  is  retired  and  proper  accounting  made  is 
sufficient  to  constitute  a  renewal.  Every  unit  of  property  must 
be  replaced  by  some  property  equal  in  value  to  the  one  retired 
if  the  capital  investment  is  kept  intact.  That  is,  if  a  machine 
which  cost  $5,000  is  taken  from  service,  property  of  the  same 
value  must  be  available  to  take  its  place.  This  may  be  a  new 
machine  similar  to  the  old  or  an  entirely  new  kind  of  property, 
but  $5,000  must  be  available  in  some  form  to  renew  or  replace 
the  machine  taken  from  service. 

The  cost  of  the  renewal  is  an  expense,  a  charge  against  the 
revenue  earned  during  the  period  the  item  is  used.  All  of  this 
expense  may  be  charged  against  the  revenue  of  the  period  in 
which  the  renewal  is  made,  in  which  case  the  replacement  policy 
is  adopted ;  or  it  may  be  charged  partly  in  each  accounting 


488  PRINCIPLES  OF  ACCOUNTING 

period  throughout  the  service  life  of  the  property  item,  in  which 
case  the  formal  depreciation  account  policy  is  used. 


THE   REPLACEMENT   POLICY 

When  the  replacement  policy  is  adopted,  the  cost  of  a  property 
item  less  the  salvage  value  is  charged  to  expense  at  the  end  of  its 
service  life.  This  is  the  most  convenient  method  to  use  in  the 
accounts  as  it  obviates  the  necessity  for  apportioning  the  depre- 
ciation over  a  series  of  accounting  periods.  The  policy  is  prop- 
erly applicable,  however,  only  to  those  properties  which  consist 
of  a  large  number  of  relatively  short-lived  property  units  which 
are  consumed  in  approximately  the  same  quantities  during 
succeeding  accounting  periods.  Railroad  ties,  telephone  poles 
and  the  like  are  illustrations.  The  number  of  units  runs  into  the 
thousands  and  because  of  the  relatively  short  period  of  service, 
five  to  eight  years  for  ties,  for  example,  the  renewals  take  place 
with  a  fair  degree  of  regularity.  It  may  be  assumed  without  any 
great  degree  of  error  that  the  value  expiration,  as  measured  by 
the  cost  of  units  retired  from  service,  corresponds  to  the  value 
decline  of  all  units  in  service  during  the  same  period.  The  fact 
that  a  class  of  asset  items  is  made  up  of  a  large  number  of  units, 
however,  is  not  conclusive  evidence  that  the  replacement  policy 
is  the  most  desirable.  The  average  number  of  retirements,  the 
tendency  of  price  changes,  the  growth  of  the  property,  and  other 
conditions  must  be  considered  before  placing  an  item  in  this 
class. 

It  may  readily  be  seen  that  this  treatment  of  the  depreciation 
of  fixed  assets  corresponds  closely  to  the  method  of  measuring 
value  expirations  of  current  assets.  Each  property  unit  is 
inventoried  at  cost  continuously  from  date  of  acquisition  to  date 
of  renewal,  and  expense  is  charged  only  when  the  item  is  com- 
pletely consumed.  The  application  of  this  policy  has  often  led 
to  incorrect  analysis  resulting  in  erroneous  entries.  A  few 
illustrations  will  serve  to  make  the  point  clear. 

A  machine  which  cost  $100  and  has.  been  carried  in  the 
Machinery  account  at  that  figure  since  the  date  of  purchase  is 
retired  from  service.  The  entries  for  recording  the  renewal, 
assuming  no  salvage  value,  are, 


THE  DEPRECIATION  ACCOUNTS  489 

Renewal  Expense       $100 

Machinery       $100 

These  entries  should  be  made  no  matter  what  is  done  about 
replacing  the  worn-out  item.  The  expense  account  must  be 
charged  in  order  to  record  the  fact  of  property  consumption 
of  $100.  Machinery,  of  course,  is  credited  because  it  is  that 
form  of  property  which  has  been  consumed. 

A  separate  Renewal  Expense  account  should  be  kept  for  each 
class  of  property  for  which  the  replacement  policy  is  used.  Such 
an  account  represents  the  cost  of  abandoning  property  and  this 
account,  together  with  the  repair  accounts  for  the  same  class  of 
property,  represents  the  total  cost  of  maintenance. 

The  expense  incident  to  the  renewal  is  measured  by  the  cost 
of  the  item  retired  minus  any  salvage  value;  yet  this  point 
is  not  always  recognized  in  the  accounts.  The  classifications 
of  certain  public  utility  commissions  define  renewal  expense  as 
the  "cost  of  replacing  in  kind"  the  property  item  retired  minus 
any  salvage  value.  This  rule  which  is  also  often  followed  by 
industrial  concerns  leads  to  certain  illogical  results  in  a  period  of 
changing  prices  which  can  best  be  explained  by  illustration. 
Suppose,  for  example,  that  the  machine  which  was  retired  (refer- 
ring to  the  preceding  illustration)  was  replaced  by  a  new  machine. 
The  new  machine  might  cost  the  same  amount  as  the  old,  or 
more,  or  less.  The  entries  in  each  case  are  of  importance. 
First  then,  if  the  new  one  cost  the  same  as  the  old,  the  entries 
would  be, 

Machinery $100 

Cash $100 

This  replaces  the  $100  in  the  Machinery  account  and  leaves 
the  valuation  of  machinery  the  same  as  before  the  renewal 
was  made.  For  convenience  in  recording  the  entries  and  to 
save  duplicate  postings,  the  two  entries  are  often  combined, 
the  debit  to  Machinery  in  the  second  offsetting  the  credit 
to  Machinery  in  the  first,  thus, 

Renewal  Expense $100 

Cash $100 


490  PRINCIPLES  OF  ACCOUNTING 

No  criticism  can  be  made  of  this  latter  entry  provided  that  it  is 
realized  that  the  expense  item  refers  to  the  dissipation  of  the 
old  machine  and  not  the  new  one. 

In  the  case  at  hand  the  rule  mentioned  above  that  the  renewal 
expense  should  be  the  cost  of  replacing  in  kind  would  lead  to  the 
same  result,  but  if  the  new  machine  costs  $110  instead  of 
$100  there  is  an  important  difference.  If  the  first  entries 
had  been  made  charging  Renewal  Expense  with  $100  and  credit- 
ing Machinery  with  $100  the  entries  for  the  purchase  would  be, 

Machinery        $110 

Cash $110 

As  a  result  of  the  two  entries  the  valuation  of  machinery  is 
increased  by  $10,  and  this  is  as  it  should  be  as  the  value  of  the 
new  machine  is  $110  and  it  should  be  stated  at  this  figure  in 
the  accounts.  Now  if  the  two  entries  were  combined  as  before 
the  result  would  be, 

Renewal  Expense $100 

Machinery 10 

Cash $110 

These  entries  recognize  what  has  been  said  before,  that  the 
expense  is  equal  to  the  cost  of  the  old  machine,  and  the  increase 
in  price  is  added  to  the  machinery  valuation.  Considerable 
stress  is  laid  on  this  point  because  if  the  rule  mentioned  above 
were  applied  in  this  case  the  following  entries  would  be  made, 

Renewal  Expense $110 

Cash $110 

It  may  be  said  that  the  cost  of  replacing  the  old  machine  in 
kind  is  the  cost  of  the  new  machine,  and  that  therefore  the  whole 
cost  should  be  charged  to  Renewal  Expense ;  but  this  obviously 
leads  to  an  overstated  expense  account  and  an  understated 
property  account. 

Two  things  are  doubtless  being  confused  when  this  rule  is 
applied  to  such  a  case,  the  physical  property,  and  the  value  of 
the  property.  It  is  true  that  the  manager  has  the  same  amount 
of  physical  property  to  work  with  after  the  renewal  as  before, 
but  it  does  not  follow  from  this  that  the  value  of  the  property 


THE  DEPRECIATION  ACCOUNTS  491 

which  he  is  using  is  the  same  as  before.  The  investment  in 
property  of  the  character  involved  has  increased.  It  has  been 
.emphasized  at  various  points  in  this  text  that  changes  in  the 
level  of  prices  should  be  reflected  in  the  accounts.  This  is  a 
case  in  point.  The  renewal  or  depreciation  cost  of  the  product 
produced  with  the  aid  of  the  old  machine  is  $100,  but  this  cost  for 
the  product  from  the  new  one  will  be  $110.  If  the  entry  just 
shown  were  made,  this  would  have  the  effect  of  charging  $110 
to  the  product  of  the  old  machine  and  further  of  understating  a 
property  account.  This  also  creates  a  secret  reserve.  If  the 
accounts  were  to  be  used  by  the  manager  in  directing  his 
course  of  production  these  entries  would  lead  to  erroneous  con- 
clusions. Likewise  security  holders  would  be  misled  as  to  the 
value  of  their  holdings  by  the  extensive  use  of  this  method  in  a 
period  of  rising  prices. 

To  alter  the  case  once  more,  suppose  that  the  new  machine 
costs  $90.  In  this  case  again  the  charge  to  Renewal  Expense  is 
$100  but  the  valuation  of  machinery  has  decreased  by  $10. 
The  entries  should  be, 

Renewal  Expense $100 

Cash $90 

Machinery 10 

This  shows  the  proper  form  of  entry  in  the  case  of  falling  prices. 
If  the  rule  of  charging  Renewal  Expense  for  the  cost  of  replacing 
in  kind  were  followed  here  the  entries  would  be, 

Renewal  Expense $90 

Cash       $90 

This  would  result  in  an  understatement  of  expenses  for  the 
preceding  period  and  an  over-valuation  of  assets  on  the  balance 
sheet.  This  procedure  is  no  more  to  be  commended  than  in 
the  former  case.  The  renewal  expense  if  the  replacement  pol- 
icy is  used  is  the  cost  of  the  retired  item  less  any  salvage  value. 


FORMAL  DEPRECIATION  ACCOUNTS 

When  formal  depreciation  accounts  are  used,  an  attempt  is 
made  to  determine  the  value  expiration  of  a  property  unit  in 


492  PRINCIPLES  OF  ACCOUNTING 

each  accounting  period  and  to  charge  that  amount  to  expense. 
The  remaining  book  value  of  each  unit,  therefore,  represents  the 
depreciated  value.  The  various  accounting  entries  possible 
under  this  policy  will  be  discussed  in  the  remainder  of  this 
chapter ;  and  the  next  chapter  will  be  devoted  to  considering  the 
methods  of  estimating  the  amount  of  depreciation. 

In  order  to  make  the  discussion  concrete  it  will  be  convenient 
to  start  with  a  hypothetical  situation  and  alter  the  conditions 
for  successive  steps  in  the  exposition.  It  will  be  assumed  that 
the  following  illustration  represents  the  original  balance  sheet 
of  an  enterprise  just  organized  and  ready  for  business.  In 
order  to  make  the  illustration  as  simple  as  possible,  the  balance 
sheet  captions  of  fixed  and  current  assets  are  used  to  designate 
all  of  the  various  types  of  property  items  in  each  group.  The 
ledger  of  the  concern  would  contain  accounts  with  building, 
machinery,  equipment,  etc.,  under  the  fixed  assets;  and  cash, 
materials,  supplies,  etc.,  under  current  assets.  For  purposes  of 
illustration  these  may  be  grouped  under  the  two  headings  shown. 

Fixed  Assets  ....  $100,000  Capital  Stock  ....  $150,000 
Current  Assets  ....  50,000 

$150,000  $150,000 

After  operating  for  one  year,  during  which  time  all  expenses 
except  depreciation  have  been  recorded,  the  statement  appears 
as  follows, 

Fixed  Assets      ....    $100,000      Capital  Stock    ....  $150,000 

Current  Assets       .     .     .        75,ooo      Current  Liabilities      .     .  5,ooo 

Revenue  (net  except  for 

depreciation)       .     .     .  20,000 

$175,000 


The  revenue  item  shown  on  the  equity  side  is  the  net  result  of 
deducting  all  expenses  from  gross  revenue  except  the  depre- 
ciation of  the  fixed  assets.  But  the  decrease  of  the  fixed  assets  is 
also  an  expense,  hence  the  figure  stated  is  not  net  revenue.  If 
the  property  has  depreciated  $10,000,  the  following  entries  would 
record  that  fact, 


THE  DEPRECIATION  ACCOUNTS  493 

Depreciation  Expense $10,000 

Fixed  Assets    (building,    machine, 

etc.) $10,000 

The  Depreciation  Expense  account  is  now  closed  against  the 
revenue  figure  and  the  balance  sheet  would  show, 

Fixed  Assets      ....      $90,000      Capital  Stock    ....  $150,000 

Current  Assets       .     .     .        7 5 ,000      Current  Liabilities      .     .  5,000 

Net  Revenue     ....  10,000 

$165,000  $165,000 

The  $10,000  item  shown  in  Net  Revenue  account  may  be  dis- 
tributed in  dividends  or  otherwise  disposed  of  in  the. interests  of 
the  stockholders.  If  other  classes  of  securities  were  outstanding, 
it  is  from  this  figure  that  the  contractual  distribution  of  interest 
must  be  met.  No  distributions  could  properly  have  been  made 
until  the  last  journal  entry  was  recorded  because,  as  was  stated 
before,  net  revenue  was  not  stated  until  depreciation  was  charged. 

The  current  asset  item  will  bear  considerable  analysis. 
The  corporation  started  operations  with  an  investment  of 
$50,000  in  current  assets  as  shown  by  the  first  balance  sheet,  and 
now  there  is  $75,000  in  the  same  type  of  property.  How  did  the 
increase  come  about?  The  various  current  asset  items  were 
constantly  shifted  from  one  form  to  another,  from  raw  materials 
and  supplies  to  finished  product  and  back  to  cash  or  accounts 
receivable  from  the  sale  of  the  product.  These  were  used  again 
for  new  supplies,  labor  service,  etc.,  and  after  producing  a 
finished  product,  resulted  in  the  acquisition  of  new  assets  —  cash 
and  accounts  receivable.  The  $75,000  item  may  not  contain 
any  of  the  original  $50,000  of  assets.  The  value  of  the  assets 
as  here  represented,  however,  may  well  be  considered  to  be  a 
part  of  the  original  investment;  that  is,  the  original  $50,000 
invested  in  current  assets  is  still  in  the  current  assets  for  it  has 
been  maintained  tkrough  the  sale  of  product  at  least  equal  in 
price  to  the  cost  of  current  assets  used  in  production.  Then 
current  assets  to  the  amount  of  $5,000  have  been  added  through 
the  purchase  of  materials  or  supplies  on  open  account  which  are 
not  yet  paid  for.  This  is  shown  in  the  fact  that  the  current 
liabilities  were  increased  by  $5,000.  Further,  another  $10,000 


494  PRINCIPLES  OF  ACCOUNTING 

is  accounted  for  in  the  fact  that  a  net  revenue  of  that  amount  has 
been  earned.  This  of  course  would  be  in  the  form  of  current 
assets  brought  in  through  sales.  Finally  the  remaining  $10,000 
increase  may  be  accounted  for  in  the  fact  that  the  amount  of  fixed 
assets  which  were  consumed,  and  included  in  the  selling  price  of 
product,  brought  in  $10,000  in  current  assets.  This  accounts 
for  the  whole  increase. 

It  is  the  last  amount  that  is  of  particular  significance  in  this 
connection.  It  might  be  said  that  a  part  of  the  value  of  the 
fixed  assets  ($10,000)  has  been  transferred  to  current  assets ; 
that  is,  that  by  charging  expense  with  the  depreciation  of  fixed 
assets  accruing  within  the  period,  an  equal  amount  of  current 
assets  received  through  sales  is  retained  in  the  business  as 
current  assets  to  offset  the  amount  of  fixed  assets  consumed.  To 
make  this  point  still  more  emphatic,  it  may  be  shown  that  the 
increases  accounted  for  by  the  other  causes  may  be  disposed  of  to 
the  present  equities  without  impairing  the  capital,  while  the 
latter  cannot.  Suppose,  for  example,  that  among  the  current 
assets  there  is  cash  $25,000.  The  current  liabilities  could  be 
paid  off  with  $5,000  of  this  sum  and  a  dividend  of  $10,000 
(equal  to  the  net  revenue  figure)  could  be  paid  out  of  the  balance. 
After  these  transactions  are  consummated,  the  balance  sheet 
would  show, 

Fixed  Assets      ....      $90,000      Capital  Stock    ....    $150,000 

Current  Assets       .     .     .        60,000  

$150,000  $150,000 

There  is  an  additional  $10,000  in  the  current  assets  over  the 
amount  originally  invested  and  this  cannot  be .  distributed  in 
dividends  without  impairing  the  capital.  Any  disbursement 
which  does  not  bring  in  assets  of  an  equal  value  at  this  point 
would  cause  a  deficit  to  appear. 

In  this  illustration,  the  credit  for  depreciation  was  marie 
directly  to  the  asset  accounts.  It  is  assumed  that  the  remaining 
balance  in  such  an  account  represents  the  actual  present  value  of 
the  property.  It  is  often  considered  desirable  to  leave  the  cost 
figures  of  all  permanent  property  items  in  the  accounts  until 
a  unit  is  actually  retired  from  service  and  to  make  the  credits 


THE  DEPRECIATION  ACCOUNTS  495 

to  a  valuation  account,  Allowance  for  Depreciation,  instead. 
The  entries  recognizing  depreciation  in  this  case  would  be, 

Depreciation  Expense $10,000 

Allowance  for  Depreciation    .     .  $10,000 

As  a  result  of  this  entry  the  fixed  assets  would  remain  the  same 
and  the  balance  sheet  after  all  other  transactions  as  before  would 
be  as  follows, 

Fixed  Assets      ....    $100,000      Capital  Stock    ....    $150,000 

Current  Assets       .     .     .        60,000      Allowance  for  Depreciation      10,000 

$160,000  $160,000 

This  represents  exactly  the  same  condition  as  the  preceding 
balance  sheet.  The  use  of  the  account  Allowance  for  Depre- 
ciation need  cause  no  difficulty  as  it  is  the  same  as  placing  tem- 
porarily in  another  account  the  credit  side  of  the  fixed  assets 
accounts. 

Each  time  that  a  unit  of  the  fixed  assets  is  retired  from  service, 
the  cost  of  the  item  minus  any  salvage  is  charged  to  the  Allowance 
for  Depreciation  account  and  credited  to  the  proper  fixed  asset 
account.  At  the  end  of  each  accounting  period,  the  accrued 
depreciation  is  charged  to  expense  and  credited  to  Allowance  for 
Depreciation.  This  account  should  therefore  always  represent 
the  difference  between  the  cost  of  the  property  items  actually  in 
service  and  the  present  value  of  those  items.  The  fixed  asset 
accounts  always  show  the  original  cost  of  the  assets  actually  in 
use.  In  the  ordinary  situation,  the  Allowance  for  Depreciation 
account  will  always  show  a  credit  balance ;  that  is,  the  present 
value  of  all  fixed  assets  taken  together  is  always  less  than  the  cost 
of  all  those  assets.  This  fact  scarcely  needs  demonstration, 
for  in  a  composite  property  in  no  case  would  all  of  the  assets  be 
renewed  at  one  time.  Some  items  last  five  years,  others  fifty 
or  more ;  in  some  years  a  large  and  costly  item  will  be  renewed, 
causing  a  large  debit  to  the  valuation  account ;  in  other  years, 
renewals  are  light  causing  small  debits  to  this  account.  The 
balance  therefore  fluctuates  from  year  to  year ;  sometimes  it 
will  be  a  large  item,  sometimes  small,  but  never  reaching  zero. 

The  amount  of  the  depreciation  charge  being  in  the  last 


496  PRINCIPLES  OF  ACCOUNTING 

analysis  an  estimate,  errors  are  likely  to  be  made.  The  charges 
might  be  too  large  or  too  small.  This  fact  may  be  discovered 
at  any  time  but  usually  not  until  the  date  of  retiring  an  item. 
The  amount  of  depreciation  which  has  been  charged  for  the 
value  decrease  in  the  unit  may  exceed  the  actual  amount 
necessary  or  it  may  not  be  large  enough.  Such  a  situa- 
tion is  bound  to  arise  and  as  soon  as  such  conditions  are 
discovered  corrective  entries  should  be  made.  If  the  previous 
charges  have  been  too  small,  Depreciation  Expense  (or  Surplus 
if  the  item  is  large)  should  be  charged  and  Allowance  for  Depre- 
ciation credited  for  the  amount  of  the  error.  If  the  converse 
situation  obtains,  the  correction  can  be  made  by  debiting  Allow- 
ance for  Depreciation  and  crediting  either  Net  Revenue  or 
Surplus.  In  case  a  machine  or  other  property  item  is  suddenly 
rendered  useless  because  of  some  unforeseen  contingency,  the 
correction  might  well  be  temporarily  made  by  debiting  a  deferred 
debit  account  as  explained  in  Chapter  X  instead  of  expense. 
As  a  general  rule  corrections  are  not  often  necessary  and  when 
required  are  not  of  much  significance.  The  regular  periodical 
charges  take  care  of  depreciation  in  a  fairly  adequate  manner. 

In  the  balance  sheet  just  under  discussion  there  is  an  additional 
$10,000  in  the  current  assets  due  to  the  fact  that  the  value  de- 
cline in  fixed  assets  has  been  charged  against  current  revenue. 
What  should  be  done  with  these  additional  assets?  Three 
different  policies  are  open,  each  being  advisable  under  certain 
conditions:  (i)  the  assets  might  be  placed  in  a  special  fund 
awaiting  the  replacement  of  the  fixed  assets  for  which  the 
depreciation  charge  was  made ;  (2)  they  might  be  given  back  to 
the  stockholders  as  a  return  of  capital ;  and  (3)  the  funds  might 
be  kept  active  in  the  enterprise  and  invested  in  either  additional 
fixed  assets  or  current  assets  or  partly  in  each.  As  each  of 
these  cases  requires  considerable  analysis  a  special  section  will 
be  devoted  to  each. 


THE   DEPRECIATION   FUND 

The  additional  current  assets  representing  the  conversion  of 
fixed  assets  may  be  placed  in  a  special  fund  which  will  always  be 
available  for  making  renewals.  Business  men  and  even  some 


THE  DEPRECIATION  ACCOUNTS  497 

accountants  often  confuse  the  depreciation  charge  as  described 
in  the  last  section  with  this  setting  up  of  a  special  fund.  The 
statement  is  frequently  made  that  the  depreciation  charge 
results  in  reserving  a  fund  to  replace  the  property  when  it  is 
worn  out.  This  does  not  necessarily  follow  as  has  already  been 
shown  for  the  establishment  of  such  a  fund  is  purely  optional 
with  the  company.  Other  policies  are  open  and  are  frequently 
advisable.  If  a  special  fund  is  set  up,  however,  the  following 
entries  equal  in  amount  to  the  Depreciation  Expense  charge  are 
made, 

Depreciation  Fund $10,000 

Cash $10,000 

At  the  time  this  entry  is  made,  $10,000  is  actually  placed  in  a 
special  cash  fund.  It  may  be  turned  over  to  a  trustee,  placed  in 
a  special  bank  account  drawing  interest,  or  may  be  invested  in 
securities  which  may  be  easily  disposed  of  when  funds  are  needed 
for  renewals.  In  any  case  these  funds  are  not  available  for 
general  business  purposes. 

After  this  entry  is  made,  the  balance  sheet  (see  the  illustra- 
tion on  page  495)  would  appear  as  follows, 

Fixed  Assets      ....    $100,000  Capital  Stock    ....    $150,000 

Depreciation  Fund     .     .        10,000  Allowance  for  Depreciation      10,000 

Current  Assets  ....        50,000  

$160,000  $160,000 

This  shows  the  same  condition  of  the  enterprise  as  the  preceding 
statement  except  that  a  part  of  the  current  assets  has  been 
labeled  "Depreciation  Fund."  The  amount  in  the  Depreciation 
Fund  account  is  just  equal  to  the  amount  in  the  Allowance  for 
Depreciation  account  on  the  other  side  of  the  balance  sheet ;  but 
neither  one  is  essential  to  the  other.  Allowance  for  Depreciation 
would  not  appear  on  the  balance  sheet  at  all  if  originally  the  credit 
had  been  made  to  the  asset  account  instead  of  to  the  valuation 
account.  In  such  a  case  the  fixed  assets  would  stand  at  $90,000, 
but  the  Depreciation  Fund  would  still  show  $10,000.  Likewise  it 
is  possible  to  have  the  Allowance  for  Depreciation  account  shown 
on  the  equity  side  and  no  fund  account  on  the  asset  side.  This 
case  will  be  shown  more  fully  in  the  next  section.  The  point  to 

2K. 


4QS  PRINCIPLES  OF  ACCOUNTING 

be  emphasized  here  is  that  there  is  no  fundamental  relation 
between  the  two  accounts.  The  Allowance  for  Depreciation 
results  from  crediting  this  valuation  account  instead  of  a  prop- 
erty account  when  a  charge  to  expense  is  made  for  depreciation. 
The  Depreciation  Fund  results  from  taking  a  certain  amount  of 
cash  out  of  the  general  cash  account  and  placing  it  in  a  special 
fund.  The  two  accounts  are  equal  in  amount  because  the  sum 
set  aside  is  supposed  to  accumulate  to  the  investment  cost  of 
the  property  item  at  the  time  it  is  renewed,  and  the  same  amount 
measures  the  value  decline.  In  some  cases  it  might  be  convenient 
to  accumulate  the  fund  on  another  basis  than  the  depreciation 
charge.  In  this  case  the  two  accounts  would  not  be  equal. 
Normally,  however,  if  a  fund  is  maintained  it  will  be  equal  in 
amount  to  the  valuation  account  balance. 

The  entries  at  the  date  of  a  renewal  when  the  fund  is  main- 
tained are  of  interest.  Suppose,  for  example,  that  a  machine 
listed  in  the  Machinery  account  among  the  fixed  assets  at  $5,000 
wears  out  and  requires  replacement.  The  old  machine  is  sold 
for  scrap  bringing  in  $50.  The  new  machine  required  to  replace 
the  old  one  costs  $6,000.  In  the  first  place,  the  entries  recording 
the  salvage  from  the  old  unit  are, 

Cash $50 

Machinery ' $50 

This  leaves  $4,950  in  the  Machinery  account  which  must  be 
written  off  against  Allowance  for  Depreciation.  If  the  estimate 
of  depreciation  has  been  correct,  there  will  have  been  just  $4,950 
charged  to  Depreciation  Expense  and  credited  to  Allowance  for 
Depreciation  during  the  service  life  of  the  machine.  Assuming 
this  to  be  the  case  the  entries  are, 

Allowance  for  Depreciation $4,950 

Machinery $4,9So 

The  old  machine  has  now  been  entirely  eliminated  from  the 
book  accounts.  Further,  it  may  be  assumed  that  $4,950  has  been 
placed  in  the  depreciation  fund  on  account  of  this  machine. 
This  amount  should  now  be  available  for  use  in  buying  the  new 
machine.  First  that  sum  will  be  transferred  to  the  general  cash 
account  and  for  this  transaction  the  entries  are, 


THE  DEPRECIATION  ACCOUNTS  499 

Cash $4,9So 

Depreciation  Fund $4,95o 

Now  the  new  machine  is  purchased  which,  as  has  been  said,  costs 
$6,000.  For  this  purchase  the  entries  are, 

Machinery $6,000 

Cash       $6,000 

It  may  be  seen  that  $4,950  of  this  cash  came  from  the  accumulated 
depreciation  fund  and  $50  from  the  sale  of  the  scrap.  The 
additional  $1,000  called  for  in  the  price  must  be  obtained  from 
other  sources.  Unless  the  firm  has  on  hand  more  cash  than  is 
needed  for  current  operations,  this  sum  must  be  obtained  through 
new  investment.  Additional  stock  may  be  issued,  or  funds  may 
be  secured  through  some  form  of  borrowing  such  as  bonds  or 
notes.  In  any  case,  an  additional  investment  of  $1,000  is 
made  in  machinery. 

It  may  be  well  to  inquire  as  to  the  advisability  of  creating  a 
special  depreciation  fund.  Should  a  firm  label  a  certain  part  of 
its  cash  receipts  from  the  sale  of  product  as  a  fund  which  can  be 
used  only  for  replacing  specific  units  of  fixed  assets  used  in  pro- 
ducing the  revenue?  In  general  a  negative  answer  might  be 
given  to  the  question.  It  would  be  better  financial  policy  to  use 
such  funds  in  ordinary  business  operations.  Cash  tied  up  in  a 
special  fund  such  as  this  cannot  be  of  as  much  service  to  a  firm 
as  it  would  be  if  invested  in  additional  equipment  or  used  as 
additional  working  capital,  in  case  these  things  are  needed. 
But  if  such  increases  in  equipment  are  not  needed,  a  fund  may 
be  advisable.  One  case  in  which  this  situation  might  obtain 
would  be  in  a  terminable  enterprise  such  as  a  mining  or  timber 
business.  If  the  fixed  capital  is  invested  in  a  mineral  deposit 
in  a  specified  place  and  there  is  no  intention  of  extending  the 
business  to  new  fields,  such  funds  would  not  be  of  service  for 
additional  equipment  and  might  be  kept  in  a  fund  until  the 
termination  of  the  enterprise.  At  this  time  the  assets  in  the  fund 
should  have  accumulated  to  a  sufficient  size  to  enable  the  cor- 
poration to  pay  off  all  securities. 

Again  if  a  continuous  enterprise  has  reached  a  relatively  static 
stage  in  development,  particularly  with  regard  to  its  fixed  plant, 


500  PRINCIPLES  OF  ACCOUNTING 

a  fund  might  be  advisable.  A  water  supply  plant,  for  example, 
may  reach  a  stage  where  no  additional  pumps  or  mains  are 
necessary  for  a  considerable  period  of  time.  The  funds  reserved 
by  the  depreciation  charge  cannot  be  put  to  a  particularly 
profitable  use  in  the  extension  and  may  be  kept  in  a  fund  at 
least  until  new  extensions  are  planned. 

DEPRECIATION  FUND  RETURNED  TO  INVESTORS 

In  either  of  the  cases  just  mentioned  a  special  fund  would  be 
justified.  The  total  investment  would  remain  unchanged  but 
the  form  of  assets  held  would  be  gradually  changing  from  fixed 
physical  property  to  cash  funds.  An  alternative  plan  in  either 
case  would  be  to  turn  the  funds  thus  freed  from  the  fixed  invest- 
ment back  to  the  security  holders. 

The  argument  for  returning  the  assets  under  consideration  to 
the  investors  runs  something  like  this.  The  original  investment 
was  made  to  enable  the  enterprise  to  secure  all  of  the  necessary 
permanent  equipment  and  working  capital  to  conduct  the  specific 
business  for  which  the  organization  was  effected.  A  part  of  the 
investment  is  converted  into  cash  in  the  ordinary  operations  of 
the  business.  Since  this  is  not  needed  in  the  enterprise,  to  place 
this  cash  in  a  special  fund  is  to  compel  the  stockholders  to 
change  the  form  of  investment  from  a  mining  business,  for 
example,  which  is  highly  speculative,  to  a  conservative  invest- 
ment. In  other  words,  the  corporation  is  reinvesting  its  stock- 
holders' funds  on  a  new  basis. 

As  applied  to  the  terminable  enterprise  this  argument  has 
considerable  force ;  in  fact  it  has  the  sanction  of  some  few  court 
decisions.  It  may  be  seen  that  the  investment  of  the  stock- 
holder gradually  changes,  when  the  depreciation  fund  is  main- 
tained, from  the  assets  of  a  mining  concern  to  assets  in  the  form 
of  a  savings  account  in  a  bank  or  in  securities  which  usually 
bear  a  very  low  rate  of  interest.  The  stockholders  may  prefer, 
and  with  some  reason,  to  have  this  fund  as  it  accumulates  paid 
over  to  themselves  to  invest  as  they  see  fit. 

In  case  such  a  procedure  is  followed,  however,  care  must  be 
exercised  to  inform  the  stockholders  as  to  what  constitutes  a 
return  of  original  investment  and  what  is  dividends  on  the 


THE  DEPRECIATION  ACCOUNTS  501 

investment.  Two  different  methods  may  be  used  to  effect 
this  result,  (i)  actually  buying  back  some  stock  with  the  cash, 
or  (2)  paying  the  cash  to  all  stockholders  pro  raid  as  a  return  of 
capital.  The  accounting  entries  in  both  cases  are  of  importance. 
Referring  to  the  balance  sheet  on  page  495  again  for  an  illus- 
tration, suppose  that  it  is  decided  to  pay  the  additional  funds  to 
stockholders  by  buying  back  $10,000  of  the  stock  at  par.  The 
entries  covering  this  transaction  would  be, 

Capital  Stock $10,000 

Cash $10,000 

and  after  these  entries  are  made,  the  balance  sheet  would  show, 

Fixed  Assets      ....     $100,000      Capital  Stock     ....    $140,000 

Current  Assets       .     .     .        50,000      Allowance  for  Depreciation      10,000 

$150,000  $150,000 

This  same  procedure  would  be  followed  each  year  until  the  end 
of  the  life  of  the  enterprise  by  which  time  all  of  the  stock  would 
have  been  bought  back  and  the  affairs  of  the  corporation  closed. 
Legal  restrictions  would  prevent  this  practice  in  some  states 
where  corporations  are  not  allowed  to  purchase  their  own  stock. 
Further  it  would  be  practically  impossible  to  buy  the  stock  back 
at  par  unless  some  provision  were  made  in  the  articles  of  in- 
corporation ;  and  if  it  were  necessary  to  pay  a  high  premium  for 
the  repurchased  stock,  it  would  be  impossible  to  return  the 
investment  on  this  basis.  In  addition  to  these  objections  there 
is  a  more  fundamental  reason  why  this  method  of  returning 
the  investment  would  usually  be  inadvisable.  It  would  be 
necessary  to  select  the  stock  of  certain  stockholders  for  can- 
cellation each  year  and  these  individuals  would  be  obliged  to 
forego  their  opportunities  for  high  profits  in  future  years  in  this 
enterprise  and  to  seek  new  fields  for  investment  long  before  they 
had  planned  to  do  so,  while  the  chances  for  gain  would  remain 
in  the  hands  of  the  favored  few  whose  stock  had  not  been 
called.  Further,  if  there  were  any  bonds  outstanding,  the 
margin  of  safety  for  the  bondholders  would  continually  de- 
crease. Securities  of  a  concern  which  planned  to  retire  stock  in 
this  manner  could  not  be  issued  to  advantage. 


502  PRINCIPLES  OF  ACCOUNTING 

The  more  reasonable  procedure  then  is  to  pay  the  funds  over 
to  the  stockholders  pro  rata.  In  case  this  is  done,  however, 
the  stockholders  should  be  apprised  of  the  fact  that  the  checks 
they  are  receiving  are  for  a  return  of  investment  and  not  a 
dividend.  All  too  often  in  the  past  mining  concerns  in  making 
such  payments  to  stockholders  have  included  the  amount  in  the 
dividend  check,  thus  leading  the  stockholder  to  treat  it  as  income 
in  his  private  budget.  This  has  resulted  from  the  practice  of 
ignoring  depreciation  altogether,  which,  of  course,  cannot  be 
commended. 

If  the  fund  is  distributed  on  a  pro  rata  basis  the  entries  record- 
ing that  fact  would  be, 

Capital  Returned $10,000 

Cash       $10,000 

and  the  resulting  balance  sheet  would  be, 

Fixed  Assets      ....    $100,000  Capital  Stock    ....    $150,000 

Capital  Returned  .  .  10,000  Allowance  for  Depreciation  10,000 
Current  Assets  .  .  .  50,000 

$160,000  $160,000 

Capital  Returned  is  a  valuation  account,  an  offset  to  the  pro- 
prietary account  Capital  Stock.  This  account  would  increase 
each  year  until  at  the  expiration  of  the  mine  it  would  be  equal 
in  amount  to  the  fixed  assets  item,  which  means  that  all  of  the 
investment  in  the  form  of  property  has  been  returned.  Current 
assets  remaining  would  be  sufficient  to  pay  off  the  balance  of 
the  claims  of  the  stockholders. 

While  the  policy  of  returning  capital  may  be  advisable  in  some 
forms  of  terminable  enterprises,  it  can  seldom  be  commended  for 
continuous  concerns.  To  return  capital  to  the  stockholders  of 
such  a  business  would  mean  that  at  a  later  date — when  a  renewal 
must  be  made  —  the  stockholders  must  be  assessed  an  amount 
equal  to  the  amounts  previously  returned.  This  not  only  would 
be  inconvenient  but  would  certainly  lead  to  misunderstandings 
and  probably  to  the  failure  to  obtain  the  funds  needed.  Further 
it  would  cause  the  investment  market  to  be  very  unsettled  and 
increase  the  risk  of  stock  purchases.  For  the  continuous  enter- 


THE  DEPRECIATION  ACCOUNTS  503 

prise  the  cash  should  be  retained  in  a  special  fund  as  explained 
in  the  preceding  section  or  else  used  for  additional  assets  in  the 
business  as  will  be  further  explained  in  the  following  section. 


THE   POLICY   OF   REINVESTING   THE   FUND   IN   THE   BUSINESS 

Normally  the  continuous  enterprise  is  a  growing  concern. 
New  capital  is  continually  needed  for  additions  to  the  plant, 
new  equipment,  additional  working  capital,  etc.  Permanent 
increases  can  ultimately  be  made  only  through  the  reinvestment 
of  net  earnings  or  through  new  investments  by  security  holders. 
But  temporarily  the  amount  reserved  by  the  depreciation  charge 
can  well  be  applied  to  such  additions.  In  fact  it  is  considered  a 
good  form  of  financiering  to  use  the  depreciation  funds  for 
additions,  even  though  new  capital  must  be  raised  for  replacing 
the  worn  out  units  at  the  time  of  abandonment.  It  is  moreover 
perfectly  proper  as  the  situation  is  the  same  as  though  the  depre- 
ciation funds  had  been  kept  for  the  renewals  and  new  capital 
raised  for  additions.  The  corporation  in  the  meantime  would 
have  been  relieved  of  the  necessity  of  issuing  new  securities  for 
some  considerable  period  and  probably  would  have  made  some 
net  saving  in  interest  accruals. 

If  this  policy  were  adopted  by  the  company  whose  balance 
sheet  is  shown  on  page  495,  and  $10,000  were  invested  in  new 
machinery,  the  entries  would  be,  as  for  any  purchase  of  a  like 
character, 

Machinery $10,000 

Cash       $10,000 

and  the  balance  sheet  after  the  purchase  would  show  the  follow- 
ing facts, 

Fixed  Assets      ....    $110,000    Capital  Stock      ....    $150,000 

Current  Assets       .     .     .        50,000    Allowance  for  Depreciation        10,000 

$160,000  $160,000 

The  net  valuation  of  the  fixed  assets  is  $100,000,  the  same  as  it 
was  at  the  start.  But  the  property  situation  is  somewhat 
different  than  before.  The  original  assets,  costing  $100,000, 


504  PRINCIPLES  OF  ACCOUNTING 

are  still  in  use  although  depreciated  by  $10,000.  The  $10,000 
obtained  from  revenues  which  covers  this  decrease  in  value  of  the 
original  assets  has  been  used  for  purchasing  additional  equipment. 
The  depreciated  value  of  the  old  assets  plus  the  cost  of  the  new 
machinery  equals  the  original  investment.  The  investment  is 
kept  intact  by  this  method.  The  book  value  of  assets  (fixed 
assets  minus  the  Allowance  for  Depreciation  balance)  will  always 
be  equal  to  the  total  amount  invested. 

At  the  time  an  item  is  renewed  the  entries  are  simple.  Sup- 
pose for  example  that  a  machine  which  cost  $2,500  is  sold  for 
junk  at  the  end  of  five  years  for  $25.  The  only  entries  necessary 
as  far  as  depreciation  accounts  are  concerned  are, 

Cash $      25 

Allowance  for  Depreciation 2,475 

Machinery $2,500 

This  takes  the  value  of  the  machine  off  the  books  entirely. 
There  may  or  may  not  be  funds  immediately  available  to  replace 
the  abandoned  machine.  If  cash  is  available  the  purchase  can 
be  made  from  such  funds,  but  if  the  cash  balance  is  not  large 
enough  to  stand  the  purchase,  additional  funds  must  be  obtained 
from  stockholders  or  through  borrowing. 

It  might  appear  on  the  face  as  though  this  were  borrowing 
to  replace  worn-out  property.  One  looking  at  the  matter  superfi- 
cially might  say  that  this  company  was  borrowing  money  to  pay 
for  a  worn-out  machine ;  but  such  a  criticism  is  evidently  unjust. 
The  loan  is  not  obtained  for  paying  for  the  old  machine,  for  this 
has  been  entirely  paid  for  out  of  revenues  during  the  life  of  the 
machine  and  the  amounts  thus  received  invested  in  additional 
equipment.  The  amount  borrowed  may  properly  be  considered 
as  new  investment  in  the  business,  the  assets  for  which  are  already 
on  hand.  The  assets  of  the  concern  are  properly  maintained. 

It  may  be  that  additional  fixed  assets  are  not  needed  in  amounts 
equal  to  the  accrual  of  depreciation  but  that  additional  working 
capital  —  current  assets  —  are  needed.  Increasing  the  inventory 
of  materials,  supplies,  etc.,  has  the  same  effect  as  purchasing  new 
items  of  permanent  property.  Some  funds  might  be  used  for 
fixed  assets  and  some  for  current,  but  the  result  is  the  same.  In 
fact  if  all  the  funds  are  not  needed  for  additions  to  either  fixed 


THE  DEPRECIATION  ACCOUNTS  505 

and  current  assets  a  part  might  be  placed  in  a  special  fund  until 
actually  needed.  This  would  be  in  effect  a  combination  with  the 
depreciation  fund  policy.  Suppose,  for  example,  that  the  $10,000 
reserved  by  the  depreciation  charge  in  the  illustrations  used 
throughout  the  chapter  could  be  used,  $5,000  for  additional 
equipment  and  $2,000  for  additional  materials,  and  that  the 
other  $3,000  was  not  immediately  desired.  This  might  be 
placed  in  a  depreciation  fund  and  the  balance  sheet  would  show, 

Fixed  Assets      ....    $105,000  Capital  Stock    ....    $150,000 

Depreciation  Fund  .  .  3,000  Allowance  for  Depreciation  10,000 
Current  Assets  .  .  .  52,000 

$160,000  $160,000 


The  fund  might  be  kept  in  this  way  as  a  sort  of  reservoir  for 
cash  not  needed  in  business  operations  immediately  but  which 
must  be  kept  in  some  form  in  the  possession  of  the  company  to 
make  good  the  depreciation  of  fixed  assets.  As  soon  as  additional 
cash  is  needed,  this  fund  can  be  "tapped"  and  used  for  the  pur- 
pose. 

The  last  illustration  should  make  much  clearer  the  point  made 
in  the  earlier  part  of  the  chapter,  that  there  is  no  necessary 
relationship  between  the  Depreciation  Fund  account  and  the 
Allowance  for  Depreciation  on  the  balance  sheet.  Either  one 
might  appear  without  the  other,  both  might  appear  equal  in 
amount,  or  both  might  appear  with  unequal  amounts  as  shown 
in  this  balance  sheet. 

As  a  final  consideration  the  point  must  once  more  be  em- 
phasized that  depreciation  is  accounted  for  satisfactorily  when 
Depreciation  Expense  is  charged  and  either  the  specific  property 
account  or  the  Allowance  for  Depreciation  account  credited, 
and  that  until  this  entry  is  made  depreciation  is  not  properly 
accounted  for.  The  question  as  to  whether  a  fund  shall  be 
maintained,  or  whether  capital  shall  be  returned  to  investors, 
or  whether  the  funds  shall  be  reinvested  in  the  property,  is 
primarily  one  of  financial  policy. 


XXIII 

METHODS  OF  MEASURING  DEPRECIATION 

THE  determination  of  the  amount  of  depreciation  to  be  entered 
in  the  formal  depreciation  accounts  in  case  this  policy  is  adopted 
is  a  matter  of  considerable  importance.  It  was  shown  in  the 
last  chapter  that  physical  measurement  together  with  market 
quotations  cannot  be  used  for  fixed  assets  in  the  same  manner 
as  for  current  assets.  Some  method  which  spreads  the  total 
depreciation  over  the  service  life  on  a  reasonable  basis  must  be 
used.  The  question  as  to  what  is  a  reasonable  basis  in  the 
ordinary  situations  and  the  methods  which  meet  these  conditions 
furnish  the  subject  matter  for  this  chapter. 

THE   BASIS   FOR   MEASUREMENT 

"  The  most  satisfactory  basis  for  measuring  the  depreciation 
of  a  property  item  if  it  could  be  used  would  be  actual  inspection. 
If  the  appraiser  could  look  at  the  property  and  make  a  reasonable 
estimate  of  its  present  value  condition  at  each  inventory  date, 
this  would  give  a  sound  basis  for  depreciation  charges.  But  such 
precision  is  impossible  in  the  vast  majority  of  cases.  The  most 
that  can  be  done  by  inspection  is  to  estimate  the  service  life  of  the 
item  and  this  fact  may  be  made  the  basis  of  an  apportionment  of 
the  depreciation  charges  to  the  various  expense  statements  during 
.that  term.  Physical  condition  and  accrued  depreciation  are 
continually  being  confused  and  for  this  reason  the  distinction 
between  the  two  terms  will  be  explained  in  some  detail. 

This  confusion  of  terms  often  leads  to  the  following  error  in 
practice.  The  physical  condition  of  a  property  item  is  expressed 
in  a  percentage  figure ;  that  is,  the  appraiser  either  by  physical 
measurement  or  other  means  of  inspection  finds  that  the  prop- 
erty item  is  less  efficient  than  when  new  and  expresses  the  pres- 

506 


METHODS  OF  MEASURING  DEPRECIATION  507 

ent  condition  as  a  certain  per  cent  of  new.  This  percentage 
figure  is  then  multiplied  by  the  original  cost  (or  cost  of  re- 
production new)  to  find  the  present  value  of  the  asset,  and  an 
illegitimate  transition  is  made  by  mathematical  computation 
from  physical  efficiency  to  value. 

The  following,  an  actual  case,  illustrates  this  point.  A  law 
on  the  statute  books  of  a  certain  state  requires  that  every  station- 
ary boiler  must  be  absolutely  scrapped  at  the  end  of  twenty  years 
from  date  of  installation  no  matter  how  high  its  production 
efficiency  on  that  date.  A  corporation  in  this  state  had  a 
boiler  which  cost  $10,000  and  was  still  in  service  in  1916  and 
valued  on  the  books  at  $8,000  although  on  that  date  it  had 
served  for  eighteen  years.  The  manager  said  that  it  was  still 
giving  service  at  eighty  per  cent  and  therefore  should  be  valued 
at  eighty  per  cent  of  cost.  This  confusion  of  physical  and  value 
facts  is  quite  common.  Obviously  a  boiler  which  has  only  two 
years  of  life  remaining  is  not  worth  four-fifths  as  much  as  another 
boiler,  of  the  same  cost,  which  has  twenty  years  of  life.  What 
manager  would  be  willing  to  pay  $8,000  for  this  boiler  in  place 
and  performing  service  if  a  new  one  could  be  obtained  at  a  cost 
of  $10,000  which  would  perform  the  same  service  for  twenty 
years?  In  general,  moreover,  the  relatively  high  percentage 
of  efficiency  of  machinery  up  to  the  very  date  of  displacement 
should  make  it  clear  that  terms  of  relative  efficiency  cannot  be 
directly  transposed  into  terms  of  value. 

That  this  fact  is'  not  clearly  understood  was  demonstrated 
again  in  the  valuation  of  a  certain  telephone  company's  plant  in 
the  spring  of  1918.  The  valuation  engineer  testified  in  court  that 
the  telephone  poles  were  worth  fifty  per  cent  of  their  cost  new. 
In  defense  of  his  statement  he  submitted  statistics  showing  that 
on  the  average  the  poles  had  rotted  at  the  ground  to  a  depth  of 
one-half  the  radius.1  If  the  value  decreases  proportionately  with 
the  progress  of  the  rot,  then  the  poles  would  not  be  worthless 
until  rotted  to  the  whole  depth  of  the  radius.  But  it  would  be 
impossible  to  allow  the  deterioration  to  approach  such  a  limit 

1  In  this  case  the  mathematical  error  was  as  gross  as  the  accounting  error. 
If  the  poles  had  rotted  to  a  depth  of  one  half  the  radius,  the  deterioration 
amounted  to  seventy-five  per  cent  instead  of  fifty  per  cent. 


508  PRINCIPLES  OF  ACCOUNTING 

as  even  a  slight  wind  would  settle  the  matter  long  before  the  rot 
reached  the  center  of  the  pole.  The  measurement  referred  to 
was  improperly  used. 

-  The  productive  efficiency,  as  implied  above,  cannot  in  the 
normal  case  be  allowed  to  fall  below  a  fairly  high  percentage  of 
the  condition  when  new.  Fifty  per  cent  in  many  cases  is  the 
lower  limit  and  eighty  or  more  is  common.  As  soon  as  it  is 
impossible  to  attain  results  set  by  these  limits,  the  item  is 
renewed.  The  following  chart  illustrates  the  point : 


10 


The  rates  of  per  cent  efficiency  are  shown  on  the  perpendicular 
axis  OA  scaled  from  100  down  to  o.  The  years  of  service  life 
are  shown  on  the  horizontal  axis  OX  from  i  to  10.  It  is  assumed 
that  the  asset  item  being  considered  cannot  be  operated  at  all 
below  seventy  per  cent  efficiency.  The  curve  shows  the  decrease 
in  efficiency  from  date  of  purchase  to  abandonment.  During  the 
first  year  the  efficiency  drops  below  ninety,  then  from  the  first 
to  the  ninth  years  there  is  a  very  slight  decrease,  while  in  the 
tenth  year  there  is  a  rapid  decline  and  the  item  is  scrapped  as 
worthless.  This,  it  is  said,  is  the  normal  situation  for  machinery 
as  the  efficiency  falls  quite  rapidly  the  first  year  down  almost  to 
the  normal.  Then  the  fall  is  scarcely  noticeable  until  the  last 
year  when  it  falls  below  the  limit  set  for  abandonment  and  it  is 
discarded.  If  depreciation  were  measured  on  the  basis  of  effi- 
ciency, the  value  curve  would  coincide  with  the  one  shown.  The 


METHODS  OF  MEASURING  DEPRECIATION  509 

charge  for  depreciation  would  be  large  the  first  year,  then  for 
most  of  the  rest  of  the  service  life  the  charges  would  be  small,  and 
finally  at  date  of  abandonment  a  very  large  amount  would  be 
charged  to  depreciation.  The  purpose  of  depreciation  accounts 
cannot  be  served  in  this  way. 

This  does  not  mean  that  the  engineer's  figures  for  productive 
efficiency  are  of  no  service  at  all  in  this  connection.  On  the 
contrary  they  are  indispensable,  in  most  cases,  though  a  different 
use  should  be  made  of  them  than  that  shown  above.  The  func- 
tion of  the  appraiser  is  to  determine  the  probable  service  life  and 
this  depends  in  some  measure  on  the  decrease  in  productive 
efficiency.  At  any  one  time,  a  judgment  can  be  made  as  to  how 
much  life  is  left  in  the  item  on  the  basis  of  present  condition. 
The  probable  date  at  which  this  will  fall  below  the  point  at  which 
it  would  be  better  to  discard  is  the  information  desired.  Given 
this  information  together  with  the  cost  figures,  and  probable 
salvage  value,  depreciation  may  be  measured  on  some  other  basis.- 

Another  basis  for  depreciation  charges  advocated  by  some 
accountants  is  the  revenue  figures.  It  is  argued  that  a  rather 
even  flow  of  income  is  desired  by  security  holders  and  that  the 
amounts  charged  to  expense  for  depreciation  can  be  made  light 
in  years  when  gross  revenues  are  small  and  heavy  when  gross 
revenues  are  large.  This  policy  would  tend  to  keep  net  revenues 
fairly  stable.  The  amount  to  be  charged  might  be  found  by 
taking  a  certain  fixed  rate  of  the  gross  revenue,  a  certain 
charge  per  unit  of  product,  or  just  arbitrary  sums  which 
would  be  very  small  or  nil  some  years  and  very  large  in  others. 
This  was  the  policy  of  railroads  before  the  Interstate  Commerce 
Commission's  rulings  compelled  the  roads  to  adopt  a  regular 
depreciation  charge.  In  years  when  traffic  was  heavy  and 
consequently  revenues  were  high  a  great  many  renewals  would 
be  made,  and  then  when  the  revenues  were  light  equipment 
which  was  practically  worthless  would  be  retained  in  service 
awaiting  a  time  when  revenues  would  cover  the  charge.  This 
policy  is  practiced  in  part  under  the  present  rules.  The  prop- 
erty units  adopted  for  accounting  purposes  are  so  large  that 
the  repairs  (replacements  of  parts  of  units)  constitute  a  large 
part  of  total  maintenance.  These  are  charged  to  expense  when 
incurred.  By  making  repairs  in  prosperous  years  and  failing 


510  PRINCIPLES  OF  ACCOUNTING 

to  make  repairs  in  lean  years,  total  maintenance  can  be  made  to 
vary  with  revenue.  The  argument  always  urged  for  this  prac- 
tice is  that  fluctuations  in  earnings  result  in  an  unsettled  condition 
in  the  security  market. 

It  must  be  admitted  that  fluctuation  in  the  dividend  rate 
produces  an  unfavorable  effect  on  the  securities  of  a.  corporation, 
and  that  it  is  desirable  to  keep  the  dividend  rate  fairly  constant ; 
but  it  does  not  follow  from  this  reasoning  that  net  revenue 
must  be  kept  fairly  stable  through  manipulating  the  expense 
accounts.  Net  revenue  is  supposed  to  represent  the  difference 
between  gross  revenues  and  expenses  for  a  period,  and  since 
both  gross  revenue  and  expenses  are  subject  to  changes  from 
period  to  period,  the  net  revenue  figure  should  also  change. 
To  use  the  depreciation  accounts  to  hold  net  revenue  constant 
is  using  it  to  misstate  the  facts,  for  net  revenue  does  fluctuate 
and  this  fact  should  not  be  covered  up.  As  much  injustice  can 
be  done  security  holders  by  presenting  income  sheets  with  stable 
income  as  by  paying  dividends  of  varying  rates  from  year  to  year. 
The  stockholder  minimizes  the  amount  of  risk  involved  if  he  sees 
the  net  revenue  figure  kept  fairly  stable,  and  therefore  Net 
Revenue  should  represent  the  facts  as  nearly  as  they  can  be 
determined. 

The  fact  that  net  revenue  fluctuates  does  not  mean  that  the 
divident  rate  must  also  fluctuate  for  dividends  can  be  kept  con- 
stant through  the  use  of  the  surplus  accounts.  In  prosperous 
years  a  part  of  the  net  revenue  may  be  carried  to  surplus  to 
await  the  year  of  depression  when  the  surplus  can  be  tapped  for 
dividends.  In  this  way  net  revenue  may  be  correctly  stated 
and  dividends  kept  stable.1 

It  may  be  that  depreciation  charges  should  be  somewhat  larger 
in  years  when  the  equipment  is  being  used  more  fully  than  in 
others,  but  the  basis  of  the  charge  should  be  actual  depreciation 
and  not  the  revenue  figure  as  the  influence  of  revenue  on  values  is 
only  general  except  in  the  case  of  intangibles.  Costs  are  the 
significant  facts  for  tangible  assets  as  has  been  shown  before, 
and  the  discounting  process  does  not  apply  to  physical  items. 

To  repeat  the  conclusion  drawn  with  respect  to  the  two  bases 
suggested,  physical  deterioration  alone  is  not  decisive  nor  is  the 

1  See  Chapter  XIII. 


METHODS  OF  MEASURING  DEPRECIATION  511 

gross  revenue  figure  in  measuring  depreciation  of  physical 
assets.  The  former  may  be  used  by  the  engineer  as  a  basis  for 
estimating  the  service  life,  but  when  this  figure  is  obtained 
the  value  decrease  must  be  determined  by  some  other  schedule. 
It  will  be  the  purpose  of  the  succeeding  sections  of  this  chapter 
to  explain  some  of  the  methods  used. 


STRAIGHT   LINE   METHOD 

The  assumption  on  which  the  straight  line  method  is  based 
is  that  a  property  item  loses  an  equal  amount  of  value  during 
each  year  of  its  service  life.  An  estimate  of  the  probable  service 
life  is  first  made.  This,  as  was  stated  in  the  preceding  section, 
is  based  on  an  investigation  of  the  physical  factors.  Further 
an  estimate  is  made  of  the  probable  salvage  value,  the  sale  value 
of  the  scrap  at  date  of  abandonment.  The  difference  between 
the  original  cost  and  salvage  value  is  total  depreciation  and  this 
amount  divided  by  the  service  life  (expressed  in  accounting 
periods)  is  the  regular  depreciation  charge.  Thus  if  a  machine 
costs  $100,  and  it  is  estimated  that  the  salvage  value  will  be  $5 
at  the  end  of  ten  years,  the  total  depreciation  is  $95,  and  the 
annual  charge  is  $9.50. 

The  reason  for  calling  this  a  straight  line  method  is  evident. 
The  following  chart  illustrates  the  situation  : 

IIOOA 

90 
80 
70 
60 
50 
40 
30 
20 
10 

Q\°  I | | \ | [ I | I        ^ 

0  1  2  3  4  5  C  7  8  0  10" 


512  PRINCIPLES  OF  ACCOUNTING 

The  line  OA  represents  the  value  expressed  in  dollars,  the  line 
OX  the  life  in  years.  The  original  value  is  $100  and  the  salvage 
value  at  the  end  of  the  tenth  year  is  $5.  The  straight  line  AB 
drawn  between  the  points  A  ($100  value  at  beginning  of  first 
year)  and  B  ($5  value  at  end  of  tenth  year)  represents  the  value 
decline  for  the  intervening  period.  An  interesting  comparison 
may  be  made  between  the  chart  on  page  508  and  this  one.  In  the 
former  the  curve  represents  the  decrease  in  efficiency  and  is 
typical  of  the  normal  physical  asset.  The  line  AB  in  this  chart 
shows  the  decrease  in  value  according  to  the  straight  line  method. 
The  two  charts  may  be  used  for  the  two  classes  of  facts  for  the 
same  asset. 

There  are  two  reasons  why  this  method  is  found  in  quite 
general  use.  First  its  simplicity  commends  it  to  the  average 
accountant.  The  figures  are  easily  obtained  and  the  entries 
can  be  made  with  very  little  computation.  Second,  in  all 
probability  the  straight  line  does  at  least  approximate  the  value 
decline.  The  values  at  two  different  dates  are  all  that  can  be 
tested  on  the  market,  one  at  date  of  purchase  and  the  other  at 
date  of  abandonment ;  the  manager  plans  to  use  the  item  quite 
constantly  throughout  the  intervening  period ;  and  it  is  therefore 
reasonable  to  expect  that  the  cost  of  using  the  item  during  one 
period  would  be  approximately  the  same  as  for  any  other. 

This  probably  is  the  fact  except  for  one  factor  which  has  not 
been  taken  into  account.  The  complete  utilization  of  the  item 
takes  time  and  hence  interest  must  be  considered.  It  was  shown 
in  an  earlier  connection  that  wherever  a  durable  asset  is  used, 
implicit  interest  enters  into  the  calculation  at  some  point.  (See 
Chapter  XV.)  The  straight  line  method  fails  to  recognize 
this  fact.  That  interest  does  and  should  enter  into  the  com- 
putations may  be  shown  in  different  ways. 

It  was  shown  in  the  last  chapter  that  when  the  depreciation 
charge  is  made  a  sum  of  assets  is  available  which  is  equal  to  the 
charge  but  which  cannot  be  used  for  dividends.  This  sum  could 
be  applied  in  one  of  three  ways :  (i)  placed  in  a  special  fund ; 
(2)  returned  to  the  investors ;  or  (3)  reinvested  in  additional 
plant.  No  matter  which  one  of  these  things  is  done,  the  invest- 
ment situation  is  changed.  In  the  first  case  the  amount  retained 
is  placed  in  a  special  fund  but  this  special  fund  is  placed  where  it 


METHODS  OF  MEASURING  DEPRECIATION 


513 


will  produce  some  revenue  —  at  least  savings  bank  interest. 
The  original  assets  then  are  producing  revenue  and  the  funds  set 
aside  for  depreciation  are  also  producing  revenue  before  they  are 
needed  for  replacement  purposes.  In  the  straight  line  method 
this  additional  revenue  is  not  considered  in  the  depreciation 
charge.  The  recognition  of  this  interest  is  simply  another  way 
of  recognizing  the  implicit  interest  in  the  valuation  of  the  original 
asset.  It  takes  time  to  obtain  the  revenues  from  the  asset.  A 
large  part  of  the  revenue  the  first  year  is  net,  a  smaller  part 
replacement  of  the  investment.  In  each  succeeding  year, 
however,  the  net  revenue  (interest)  element  decreases  and  the 
return  of  investment  increases. 

Another  way  of  bringing  out  the  point  very  clearly  is  this. 
The  fund  which  is  set  aside  is  to  be  used  for  replacing  the  asset 
at  the  time  it  is  worn  out.  This  being  the  purpose  the  interest 
earned  on  the  fund  should  be  added  to  the  fund  and  not  considered 
as  outside  revenue.  The  following  table  shows  the  results  of 
using  the  straight  line  method  to  accumulate  such  a  fund  to 
replace  the  $100  machine  mentioned  above  when  interest  can  be 
earned  at  the  rate  of  five  per  cent. 


YEAR 

DEPRECIATION  FUND 
FIRST  OF  YEAR 

INTEREST  ON  FUND 

DEPRECIATION 
CHARGE 

DEPRECIATION  FUND 
END  OF  YEAR 

I 

O.OO 

O.OO 

9-50 

9-50 

2 

9-5° 

.48 

9-50 

19.48 

3 

19.48 

•97 

9-50 

29-95 

4 

29-95 

1.50 

9-50 

40.95 

5 

40.95 

2.05 

9-50 

52.50 

6 

52.50 

2.62 

9-50 

64.62 

7 

64.62 

3-23 

9-50 

77-35 

8 

77-35 

3.87 

9-50 

90.72 

9 

90.72 

4-54 

9-50 

104.76 

10 

104.76 

5-24 

9-50 

119.50 

The  fund  actually  accumulates  to  $119.50  while  the  depre- 
ciation fund  required  is  only  $95.00.  The  $24.50  difference  is 
interest  earned  on  the  fund.  The  fund  accumulated  to  more 
than  was  called  for  because  the  sum  annually  placed  in  the  fund 
was  larger  than  necessary.  But  the  annual  increase  in  the 

2L 


514  PRINCIPLES  OF  ACCOUNTING 

fund  was  obtained  through  the  depreciation  charge.  Depre- 
ciation charges  then  have  been  improperly  distributed  as  be- 
tween years.  Expenses  have  been  stated  too  large  at  least  in 
the  early  years  and  net  revenue  has  accordingly  been  stated  too 
low.  This  understatement  of  net  revenue  is  finally  corrected, 
of  course,  as  shown  by  the  fact  that  the  fund  is  greater  than 
needed  at  the  renewal  date,  and  the  final  result  at  the  end  of  the 
ten-year  period  is  the  same  as  though  interest  had  been  recog- 
nized ;  but  the  periodical  statements  throughout  the  ten-year 
period  contain  this  element  of  error. 

The  same  situation  obtains  in  case  the  fund  is  returned  to 
the  stockholders,  for  here  the  interest  earning  on  the  fund  is  paid 
directly  to  the  stockholders.  The  net  revenue  from  operation 
in  the  early  years  is  understated  but  the  amount  of  the  under- 
statement comes  back  in  the  form  of  interest  received  by  the 
stockholder  on  the  capital  which  has  been  returned  to  him.  The 
interest  calculation  must  be  made  even  though  the  fund  is  not 
kept  in  the  corporation's  possession. 

Finally  if  the  fund  is  reinvested  in  additional  assets  for  the 
company,  the  same  conditions  arise.  The  new  investment  will 
be  made  only  in  case  revenue  can  be  earned  sufficient  to  cover 
interest.  In  this  case  the  revenue  from  the  fund  is  received  by 
the  company  only  not  specifically  as  interest,  as  it  is  a  part  of 
the  general  revenue  of  the  concern.  In  any  case  then  it  would 
seem  that  interest  must  be  considered  in  the  depreciation  charge. 

The  chief  methods  advocated  for  taking  care  of  the  interest 
element  are  the  sinking  fund  and  the  compound  interest  methods. 
These  will  be  considered  in  the  next  two  sections. 

Before  going  on  to  this  discussion,  however,  it  might  be  well 
to  make  one  further  statement  in  defense  of  the  straight  line 
method  from  the  practical  standpoint.  Depreciation  in  the  last 
analysis  is  an  estimate.  The  service  life  as  stated  in  advance  is 
the  judgment  of  the  manager  or  valuation  engineer ;  in  very  few 
instances  will  the  final  results  coincide  with  the  original  estimate ; 
and  corrections  must  be  made  as  soon  as  an  error  in  judgment  has 
been  discovered.  In  all  probability  therefore  the  errors  in 
estimate  will  in  large  measure  at  least  offset  the  errors  from 
omitting  the  interest  calculation.  The  importance  of  this 
consideration  is  minimized  as  statistics  of  service  life  become  more 


METHODS  OF   MEASURING  DEPRECIATION 


515 


accurate  through  the  use  of  experience  tables  and  as  equipment 
becomes  more  standardized.  The  more  accurate  the  estimates 
of  service  life,  the  more  important  it  is  to  take  the  interest 
element  into  account. 


THE    SINKING   FUND   METHOD 

The  annual  charge  for  depreciation  under  the  sinking  fund 
method  is  an  annuity  which  will  accumulate  at  a  given  rate  of 
interest  to  the  cost  less  salvage  value  at  the  time  a  property  item 
is  abandoned.  An  amount  equal  to  the  annual  charge  is 
placed  in  a  special  fund  each  year,  hence  this  method  can  be 
used  only  when  the  special  fund  is  maintained.  As  an  illustration 
of  this  method,  the  case  of  the  machine  illustrated  under  the 
straight  line  method  may  be  used.  That  is,  the  machine  costs 
$100,  will  last  ten  years  and  have  a  salvage  value  of  $5.  Further 
it  may  be  assumed  that  the  fund  can  be  invested  at  five  per  cent 
convertible  annually.  The  annuity  which  will  accumulate  to 
$95  (cost  less  salvage  value)  in  ten  years  may  be  found  by  the 
use  of  formula  (25)  in  Chapter  XVI.  This  amounts  to  $7.55, 
and  this  sum  is  charged  to  Depreciation  Expense  each  year  and 
is  credited  to  Allowance  for  Depreciation.  The  same  sum  is 
placed  in  a  special  fund  to  accumulate  to  the  desired  amount. 
The  following  table  shows  the  situation  from  the  first  to  the 
tenth  years  inclusive. 


(I) 

(2) 

(s)              DEPRECIATION             »' 

(6) 

YEAR 

FUND  BEGIN- 
NING OF  YEAR 

FUND  END  OF 
YEAR 

Interest 

Annuity  pay- 
ment 

Total 

I 

$  O.OO 

$   O.OO 

$  7-55 

$  7-55 

$  7-55 

2 

7-55 

.38 

7-55 

7-93 

15.48 

3 

15.48 

.78 

7-55 

8-33 

23-81 

4 

23.81 

1.19 

7-55 

8-74 

32.55 

5 

32.55 

1.63 

7-55 

9.18 

41-73 

6 

41-73 

2.09 

7-55 

9.64 

51-37 

7 

Si-37 

2.57 

7-55 

IO.I2 

61.49 

8 

61.49 

3-08 

7-55 

10.63 

72.12 

9 

72.12 

3.61 

7-55 

ii.  16 

83.28 

10 

83.28 

4.17 

7-55 

11.72 

95.00 

Total          .     .     . 

$19.50 

$75-50 

$95.00 

516  PRINCIPLES  OF  ACCOUNTING 

The  amounts  in  column  (4)  are  charged  to  Depreciation  Expense 
and  credited  to  Allowance  for  Depreciation  for  each  year.  The 
same  amount  is  placed  in  a  special  fund  and  the  entries  are  a 
debit  to  Depreciation  Fund  and  a  credit  to  Cash.  The  total 
charge  to  expense  in  this  way  is  $75.50  during  the  ten  years. 
The  additional  $19.50  necessary  to  bring  the  fund  up  to  the 
required  amount  is  obtained  through  the  interest  earned  on  the 
fund  as  shown  in  column  (3).  It  is  customary  to  record  the 
receipt  of  these  funds  as  follows, 

Depreciation  Fund $.38 

Allowance  for  Depreciation       .     .     .  $.38 

the  amount  of  the  entries  being  the  figures  shown  for  the  different 
years  in  column  (3).  The  debit  is  made  to  a  fund  account 
(asset)  and  the  credit  to  a  valuation  account.  This  shows  the 
fact  that  the  operating  expenses  cover  the  annuity  charges 
exclusive  of  interest  while  the  remainder  of  the  total  depreciation 
is  raised  from  outside  sources. 

The  fact  that  a  lesser  sum  than  the  total  depreciation  is 
charged  to  expense  accounts  has  often  led  to  the  erroneous 
conclusion  that  this  is  a  cheaper  method  of  accounting  for  depre- 
ciation than  the  straight  line  or  other  methods.  It  is  said  that 
it  costs  the  company  only  $75.50  to  raise  a  fund  of  $95.00  and 
the  expense  figures  are  submitted  as  evidence.  Such  reasoning 
results  from  merely  looking  at  the  superficial  aspects  of  the  case. 
It  is  true  that  expense  is  charged  with  the  smaller  amount  and 
that  the  fund  accumulates  to  the  larger,  but  in  the  entries  which 
are  made  the  accumulation  of  interest  (which  is  a  revenue)  is 
credited  to  a  valuation  account.  Failure  to  credit  revenue  to  a 
revenue  account  has  the  same  net  effect  on  the  available  net 
revenue  as  though  the  revenue  account  had  been  credited  and 
expense  charged  for  the  larger  sum.  To  illustrate  the  point, 
the  interest  received  might  have  been  credited  to  the  Interest 
account  as  follows  and  the  increase  in  the  fund  through  interest 
shown  by  the  entries, 

Depreciation  Fund $.38 

Interest $.38 


METHODS  OF  MEASURING  DEPRECIATION  517 

Now  in  order  to  increase  the  valuation  account  by  the  proper 
amount,  these  entries  must  be  made, 

Depreciation  Expense $.38 

Allowance  for  Depreciation       .     .     .  $.38 

If  these  two  journal  entries  were  made  for  the  sums  shown  in 
column  (3)  there  could  be  no  question  about  the  total  cost  under 
the  sinking  fund  method  being  equal  to  the  total  depreciation. 
Yet  the  net  effect  on  the  net  revenue  available  for  distribution 
to  the  equities  is  the  same  under  the  former  case  as  in  the  latter. 

The  absurdity  of  the  claim  can  be  seen,  however,  without 
resort  to  an  accounting  demonstration.  If  a  certain  amount 
must  be  available  at  a  certain  date  in  the  future  for  any  purpose 
it  must  be  advanced  in  some  form  by  the  investors.  Funds  do 
not  drop  from  the  skies.  Either  new  investments  are  made  by 
the  investor  or  revenue  from  a  present  investment  is  allowed 
to  accumulate.  Any  other  situation  would  be  impossible  in 
ordinary  commercial  practice  unless  a  gift  were  made  by  some 
one  other  than  an  investor.  The  cost  to  the  investor  is  equal 
to  the  total  depreciation. 

The  sinking  fund  method  produces  the  results  desired  when  a 
special  fund  is  set  aside.  This  special  fund  is  advisable,  as  was 
shown  in  the  last  chapter,  only  (i)  for  a  terminable  enterprise 
to  retire  the  securities  at  par  when  the  assets  are  exhausted, 
or  (2)  for  a  continuous  enterprise  when  the  funds  are  not  needed 
for  additions  and  betterments. 


THE   COMPOUND   INTEREST   METHOD 

The  valuation  committee  of  the  American  Society  of  Civil 
Engineers  has  given  the  name  compound  interest  to  a  method 
which  applies  the  sinking  fund  principle  to  cases  where  funds 
are  used  for  additions  to  the  property.1  It  is  recognized 
that  if  the  sums  retained  by  the  depreciation  charge  are  re- 
invested in  the  property  a  revenue  will  result  from  the  invest- 
ment. That  is,  by  increasing  any  of  the  factors,  the  product 

1  See  Report  of  the  Special  Committee  to  Formulate  Principles  and  Methods 
for  the  Valuation  of  Railroads  and  other  Public  Utilities,  Publication  of  the 
American  Society  of  Civil  Engineers,  Oct.  28,  1916,  page  1861. 


5i 8  PRINCIPLES  OF  ACCOUNTING 

will  increase,  thus  bringing  in  net  revenue  on  the  investment. 
The  additional  revenue  thus  obtained  is  the  same  in  nature  as  the 
interest  earned  on  the  fund  in  the  sinking  fund  method.  In 
this  case,  however,  the  income  on  the  fund  is  received  in  the 
general  revenue  resulting  from  the  sale  of  product  or  service. 
It  is  not  specifically  earmarked,  "interest  on  depreciation 
fund,"  but  is  a  part  of  the  gross  revenue  of  the  concern. 

It  may  be  assumed  with  propriety  that  the  amount  of  revenue 
which  can  be  attributed  to  the  fund  thus  reinvested  is  equal  in 
amount  to  the  interest  which  would  be  paid  for  a  loan  of  capital 
for  the  same  purpose.  Since  this  is  credited  to  gross  revenue, 
the  amount  of  the  interest  computation  each  year  must  be 
charged  to  Depreciation  Expense.  The  method  may  be  illus- 
trated by  using  the  example  given  for  the  sinking  fund  method  in 
the  preceding  section.  The  total  depreciation  on  the  machine  is 
$95  and  the  period  is  ten  years.  It  is  assumed  that  the  interest 
rate  on  capital  borrowed  for  this  type  of  business  is  five  per  cent. 
The  first  step  is  to  find  the  annuity  which  will  accumulate  to  $95 
in  ten  years  at  five  per  cent.  This  is,  as  was  shown  above, 
$7.55.  This  is  the  charge  for  depreciation  the  first  year,  thus, 

Depreciation  Expense $7-55 

Allowance  for  Depreciation  ....  $7-55 

No  other  specific  entry  is  made  but  the  amount  thus  reserved 
is  used  in  business  operations.  Now  at  the  end  of  the  second 
year  the  same  annuity  charge  is  made  for  depreciation  and  in  addi- 
tion the  amount  which  is  earned  on  the  $7.55  previously  charged, 
$.38.  The  entries  then  would  be, 

Depreciation  Expense $7-93 

Allowance  for  Depreciation       .     .     .  $7-93 

Then  at  the  next  year  the  entry  will  be  $7.55  plus  the  interest 
on  all  that  has  been  reserved  up  to  this  time.  At  each  succeed- 
ing year  the  same  method  is  applied  to  determine  the  amount  of 
the  charge.  The  amount  of  the  charge  to  Depreciation  Expense 
for  each  year  is  the  sum  of  the  annuity  and  the  interest  for  the 
corresponding  year  under  the  sinking  fund  method.  For  the 
example  being  considered,  these  amounts  are  shown  in  column 


METHODS  OF  MEASURING  DEPRECIATION  519 

(5)  of  the  table  on  page  515.  The  effect  on  the  available  net 
revenue  is  the  same  as  under  the  sinking  fund  method  for  the 
same  rate  of  interest.  It  is  possible,  of  course,  that  the  rate  of 
interest  used  in  the  compound  interest  method  may  be  higher 
than  for  the  sinking  fund  method.  In  the  former  the  rate  is 
determined  by  the  interest  rate  for  investments  in  the  indi- 
vidual concern  while  in  the  latter  it  is  determined  by  the  in- 
terest rate  on  conservative  investments  in  other  concerns. 

It  is  sometimes  said  that  this  is  an  increasing  charge  method 
as  the  expense  for  depreciation  increases  from  year  to  year. 
But  the  person  who  makes  this  statement  is  simply  looking  at 
the  growth  of  the  expense  charge  entry  and  fails  to  take  into 
consideration  the  fact  that  gross  revenues  are  increasing  (with 
respect  to  the  asset  item)  at  least  proportionately.  In  other 
words,  a  part  of  the  net  revenue  from  the  reinvested  funds  is 
considered  as  a  part  of  the  gross  revenue  of  the  old  asset.  The 
actual  expense  of  keeping  the  asset  in  service  caused  by  depre- 
ciation therefore  is  the  same  each  year.  This  is  probably  the 
reason  that  the  compound  interest  method  was  originally  called 
the  equal  annual  payment  method  in  the  preliminary  report  of 
the  committee  in  1913. 

The  question  might  be  raised  as  to  whether  interest  in  this  case 
is  not  being  charged  as  an  expense  which  should  instead  be 
charged  against  net  revenue.  That  is,  since  the  increase  in  the 
depreciation  charge  is  obtained  by  an  interest  computation,  the 
additional  amount  is  interest.  This,  however,  is  not  the  case. 
Interest  chargeable  to  net  revenue  is  contractual  interest,  a 
distribution  to  the  equities.  There  is  no  distribution  to  the 
equities  in  this  case.  The  amount  charged  is  a  part  of  total 
depreciation  which  is  an  expense.  Interest  calculations  are 
brought  in  simply  as  a  method  of  computing  expense  charges 
between  accounting  periods.  The  amount  is  not  a  return  on 
capital  but  a  return  of  capital.  The  reason  for  using  the  interest 
computation  has  been  shown.  This  is  simply  a  recognition  of 
the  fact  that  time  is  consumed  between  the  returns  of  the  parts 
of  the  investment  in  a  fixed  asset  and  the  use  of  the  funds  returned 
for  replacement  purposes.  The  productive  use  of  these  funds 
in  the  meantime  in  the  enterprise  is  taken  into  account  through 
the  computations  referred  to. 


520  PRINCIPLES  OF  ACCOUNTING 

The  compound  interest  method  is  the  most  accurate  for 
accounting  for  depreciation  of  a  durable  physical  asset  when  the 
funds  reserved  are  reinvested  in  the  business.  It  makes  a  correc- 
tion of  the  straight  line  method  in  that  it  recognizes  the  interest 
element.  One  observation  may  be  made  in  comparing  these  two 
methods.  As  the  rate  of  interest  employed  in  the  compound 
interest  method  is  reduced  the  charges  approach  the  straight  line 
charges  as  a  limit.  If  the  rate  of  interest  were  taken  as  zero  as 
an  extreme  case  the  two  methods  would  be  identical.  When  the 
rate  of  interest  which  might  be  employed  is  very  small  and  the 
possibility  of  error  in  estimating  the  service  life  of  an  item  is 
large,  there  is  little  to  choose  between  the  two.  With  greater 
precision  in  estimating  service  life,  however,  the  compound 
interest  method  is  the  more  accurate. 

PRESENT  VALUE  OF  FUTURE  REVENUE  METHOD 

The  present  value  of  future  revenue  method  may  be  used  for 
measuring  depreciation  of  any  asset  the  revenue  from  which 
is  known  in  advance.  This  is  true  of  the  intangible  assets  as  a 
class,  and  as  was  shown  in  Chapter  XVIII  is  also  true  of  securities 
owned.  The  original  value  or  purchase  price  is  based  upon  the 
revenue  to  which  the  asset  gives  title.  It  is  the  present  value 
of  these  sums  at  the  market  rate  of  interest  which  determines 
the  purchase  price.  Then  the  value  at  the  end  of  each  accounting 
period  throughout  the  life  of  the  property  item  is  the  discounted 
value  of  the  remaining  future  revenue  items.  Suppose,  for 
example,  that  the  X  Company  purchases  a  patent  right  from 
Y  which  gives  an  advantage  over  all  competitors  equal  to  $500 
per  year  and  that  this  advantage  will  be  maintained  for  a  period 
of  ten  years,  after  which  the  right  expires.  The  purchase  price 
of  this  asset  will  be  the  discounted  value  of  the  ten  $500  revenues 
attributable  to  the  patent  right  at  thennarket  rate  of  interest  for 
this  form  of  investment.  If  the  rate  were  six  per  cent  the  pur- 
chase price  and  original  value  would  be  $3,680.04.  The  value  at 
the  end  of  the  first  year  would  be  found  by  discounting  the  re- 
maining nine  revenue  items  at  six  per  cent  which  gives  $3,400.85. 
The  depreciation  for  the  year  is  the  difference  between  the  two 
quantities  or  $279.19.  The  depreciation  for  each  succeeding 


METHODS  OF  MEASURING  DEPRECIATION 


521 


year  would  be  found  in  the  same  way.  The  following  table 
shows  the  book  value  at  the  beginning  of  each  year  based  on  the 
present  value  of  the  future  revenues,  the  revenue  received  during 
the  year,  the  depreciation  charge,  the  net  revenue  from  the  item 
and  the  rate  of  net  revenue  to  the  book  value  for  the  year. 


(I) 

(2) 

(3) 

(4) 

(5) 

(6) 

BOOK  VALUE 

DEPRECIATION 

RATE    OF    NET 

YEAR 

BEGINNING 

REVENUE 

CHARGE 

NET  REVENUE 

REVENUE  TO 

OF  YEAR 

DURING  YEAR 

BOOK  VALUE 

I 

$3,680.04 

$500 

$279.19 

$220.8l 

6% 

2 

3,400.8s 

500 

295-95 

204.05 

6 

3 

3,104.90 

500 

3I3-7I 

186.29 

6 

4 

2,791.19 

500 

332.53 

167.47 

6 

5 

2,458.66 

500 

352.48 

I47-52 

6 

6 

2,106.18 

500 

373-63 

126.37 

6 

7 

i,732.55 

500 

396.04 

103.96 

6 

8 

1,336.51 

500 

419.81 

80.19 

6 

9 

916.70 

500 

445-oo 

55-oo 

6 

10 

471.70 

5OO 

471.70 

28.30 

6 

Total    .... 

$5,ooo 

$3,680.04 

$1,319.96 

There  are  two  facts  of  particular  significance  in  this  table. 
In  the  first  place,  the  rate  of  net  revenue  to  book  value  remains 
constant  throughout  the  whole  period  as  shown  in  column  (6). 
This,  of  course,  must  necessarily  be  the  case  since  the  same  rate 
is  used  each  year  for  determining  the  present  values  of  future 
revenue.  If  the  market  rate  of  interest  for  the  type  of  asset 
being  considered  should  change,  however,  there  would  be  a 
change  in  the  rate  realized,  a  result  brought  about  by  using  the 
new  rate  in  obtaining  the  present  values  of  the  sums. 

In  the  second  place  column  (4),  showing  the  depreciation  for 
each  year,  gives  the  same  figures  as  would  be  obtained  through 
using  the  compound  interest  method  at  the  same  rate  of  interest. 
That  is,  if  the  six  per  cent  rate  of  interest  were  used  for  the  com- 
pound interest  rate  for  an  asset  which  cost  $3,680.04,  had  a 
service  life  of  ten  years  and  no  salvage  value,  the  depreciation 
charges  would  be  the  same  as  those  shown  for  the  present  value 
of  future  revenue  method.  The  reason  for  this  may  readily  be 
seen.  In  this  case  $3,680.04  is  the  present  value  of  an  annuity  of 


522 


PRINCIPLES  OF  ACCOUNTING 


$500  per  year  for  ten  years  at  six  per  cent  and  column  (4)  of  this 
table  is  that  part  of  the  revenue  items  which  represents  the  return 
of  investment.  The  return  of  the  investment  in  an  annuity 
always  progresses  in  conformity  with  the  growth  of  a  sinking 
fund.1  The  compound  interest  charges  also  proceed  in  con- 
formity with  the  growth  of  a  sinking  fund.  Therefore  the  depre- 
ciation charges  under  the  present  value  of  future  revenue  method 
and  the  compound  interest  method  are  the  same  in  case  the 
revenue  from  the  asset  is  an  annuity. 

The  present  value  of  future  revenue  method  does  not,  however, 
always  give  the  same  results  as  the  compound  interest  method. 
In  case  the  revenues  do  not  constitute  an  annuity,  the  methods 
differ.  Suppose,  for  example,  that  some  form  of  intangible 
asset  is  purchased  which  will  bring  in  $25  the  first  year;  $25, 
the  second  ;  $20,  the  third ;  $20,  the  fourth ;  nothing,  the  fifth ; 
$18,  the  sixth ;  $18,  the  seventh ;  $14,  the  eighth ;  $14,  the  ninth ; 
and  $22,  the  tenth,  and  that  the  purchase  price  is  made  on  a  five 
per  cent  basis.  The  price  would  be  the  sum  of  the  present 
values  of  each  of  the  sums  at  a  five  per  cent  rate  of  interest,  and 
this  gives  $138.45.  The  following  table  represents  the  same 
information  for  this  asset  on  the  present  value  of  future  reve- 
nue method  as  was  given  in  the  preceding  table. 


(I) 

(2) 

(3) 

(4) 

(5) 

(6) 

YEAR 

BOOK  VALUE 
BEGINNING 
OF  YEAR 

REVENUE 

DEPRECIATION 
CHARGE 

NET 
REVENUE 

RATE  OF  NET 
REVENUE  TO 
BOOK  VALUE 

I 

$138.45 

$25.00 

$18.08 

$6.92 

5% 

2 

120.37 

25.00 

18.98 

6.02 

5 

3 

101.39 

2O.OO 

14-93 

5.07 

5 

4 

86.46 

2O.OO 

15.68 

4.32 

5 

5 

70.78 

O.OO 

—3-54 

3-54 

5 

6 

74-32 

iS.OO 

14.29 

3-7i 

5 

7 

60.03 

18.00 

15.00 

3.00 

•  5 

8 

45-03 

14.00 

ix-75 

2.25 

5 

9 

33-28 

14.00 

12-33 

1.67 

5 

10 

20.95 

22.OO 

20.95 

1.05 

5 

Total    .... 

$176.00 

$138-45 

$37-55 

1  See  table  for  apportionment  of  annuity  payments  on  page  377. 


METHODS  OF   MEASURING  DEPRECIATION  523 

The  values  in  column  (2)  are  found  by  obtaining  the  discounted 
values  of  the  remaining  revenue  items  at  the  beginning  of  each 
year.  Column  (3)  is  the  revenue  for  each  year,  column  (4), 
the  depreciation  (difference  between  book  value  beginning  and 
end  of  each  year),  column  (5),  the  net  revenue,  and  column  (6), 
the  rate  of  net  revenue  to  book  value.  Column  (6)  shows  the 
rate  to  be  constant  again  at  five  per  cent.  This  would  necessarily 
be  the  case  if  five  per  cent  were  used  in  the  valuation  throughout 
ten  years. 

It  should  be  noted  that  in  the  fifth  year  there  is  no  revenue 
and  that  during  that  year  the  property  appreciates  by  $3.54, 
and  this  gives  a  return  of  five  per  cent  on  the  investment.  It 
would  seem  that  to  increase  the  property  valuation  during  a 
year  when  there  is  no  revenue  is  improper,  but  if  the  assump- 
tion be  accepted  that  the  value  is  determined  by  the  future 
revenues,  the  property  actually  appreciates  during  the  fifth 
year.  There  are  five  remaining  revenues  at  the  beginning  of 
the  fifth  year,  the  same  five  revenues  are  remaining  at  the  end  of 
the  fifth  year,  but  are  all  one  year  nearer  and  are,  therefore, 
more  valuable. 

The  entries  for  the  fifth  year  would  be  the  reverse  of  those  for 
other  years.  That  is,  the  book  value  would  be  increased  by  a 
debit  to  Allowance  for  Depreciation  and  a  credit  to  Revenue 
(the  opposite  of  a  charge  to  Depreciation  Expense)  thus, 

Allowance  for  Depreciation $3-54 

Revenue  (from  Appreciation)    ...  $3-54 

This  is  an  extreme  case,  for  it  is  doubtful  whether  many  in- 
tangible assets  are  sold  where  the  revenues  of  such  unequal 
amounts  are  definitely  known  in  advance.  The  case  is  possible, 
however,  and  the  illustration  serves  to  show  how  this  method 
differs  from  the  compound  interest  method.  Changes  in  the 
amount  of  revenue  directly  attributable  to  the  asset  are  the  basis 
for  changes  in  the  value  of  the  asset.  In  the  case  of  the  compound 
interest  method,  no  attempt  is  made  to  determine  the  revenue 
attributable  to  the  asset,  and  the  depreciation  charges  are  based 
on  the  cost  figures. 

The  present  value  of  the  future  revenue  method  is  the  proper 


524  PRINCIPLES  OF  ACCOUNTING 

one  for  use  in  the  case  of  intangible  assets,  or  other  assets  where 
the  purchase  and  sale  price  depends  on  the  discounting  of  the 
revenues  applicable  to  the  asset.  It  cannot  be  applied  to  physical 
property  items,  however,  and  this  fact  must  be  emphasized.  It 
has  been  suggested  that  this  method,  producing  as  it  does  a  uni- 
form flow  of  net  revenue,  should  be  applied  in  principle  to  the 
tangible  assets  in  order  to  produce  an  even  flow  of  net  revenue 
from  such  property ;  but  this  argument  is  unsound.  In  the  first 
place  it  is  impossible  to  forecast  the  revenues  from  a  physical 
property  item  or  even  to  determine  the  amount  attributable  to 
such  an  asset.  This  would  prohibit  the  use  of  this  method  on  a 
scientific  basis.  At  best  it  would  only  be  possible  to  vary  the 
depreciation  charges  directly  with  the  gross  revenue  figure  and 
this  would  be  indeed  a  rough  approximation.  Further  it  is  not 
the  purpose  of  depreciation  accounts  to  equalize  the  net  revenue 
figure  as  was  stated  earlier  in  the  chapter.  Net  revenue  from  the 
use  of  productive  agents  does  fluctuate  from  year  to  year  and 
the  accounts  should  show  this  fact.  As  well  juggle  the  labor 
expense  accounts  to  produce  an  even  flow  of  net  revenue  as 
the  depreciation  accounts.  Depreciation  charges  in  the  case  of 
physical  property  items  must  be  based  upon  cost  figures  without 
reference  to  revenue. 


MISCELLANEOUS  METHODS 

The  methods  which  have  been  described  are  the  most  im- 
portant. One  or  another  will  fit  the  ordinary  cases  which  arise 
in  practice.  There  are  a  great  many  other  methods  which  have 
been  suggested  at  various  times,  however,  some  of  which  will 
bear  mentioning. 

It  is  sometimes  suggested  that  repair  charges  be  included  in  the 
calculation  of  the  depreciation  computation.  Repairs,  it  is 
said,  constitute  a  replacement  of  a  part  of  the  value  of  a  prop- 
erty item  and  consequently  make  good  some  depreciation; 
and  it  is  urged  that  in  many  cases  it  is  found  that  the  repair 
charges  do  not  spread  evenly  over  the  service  life  of  an  item.  A 
locomotive,  for  example,  will  have  only  minor  repairs  for  a  period 
of  three  or  four  years  and  then  be  placed  in  the  shops  for  a 


METHODS  OF  MEASURING  DEPRECIATION  525 

general  overhauling  necessitating  heavy  repair  charges.  These 
charges  make  good  a  certain  amount  of  depreciation  of  the  pre- 
ceding four  years,  and  it  is  said  that  they  should  be  spread 
in  the  expense  accounts  of  those  years  instead  of  being  charged 
all  in  the  one  year  as  is  done  according  to  current  practice.  In 
general  this  plea  is  that  the  depreciation  charge  should  be  suffi- 
cient to  cover  the  repair  costs  as  well  as  the  renewal,  and  there  is 
considerable  force  to  this  argument  since  in  many  cases  in  prac- 
tice the  repair  charges  fluctuate  very  greatly  from  year  to  year. 
In  general,  however,  the  error  consists  in  choosing  too  large  a 
unit  for  accounting  purposes.  It  was  shown  in  the  last  chapter 
that  the  distinction  between  repairs  and  renewals  is  arbitrarily 
based  on  the  definition  of  the  unit.  If  it  is  found  that  the  repair 
charges  do  vary  disproportionately  between  periods,  a  change 
in  the  choice  of  the  unit  may  remedy  the  situation.  Instead  of 
considering  the  locomotive  as  a  unit,  for  example,  the  different 
parts  may  be  accounted  for  on  this  basis.  There  must  be  some 
line  drawn  for  practical  purposes,  however,  and  it  would  be 
inadvisable  to  make  the  units  so  small  that  all  repairs  would 
be  accounted  for  in  this  way  as  the  distinction  between 
repairs  and  renewals  is  of  sufficient  importance  to  warrant  its 
retention. 

The  annuity  method  is  also  worthy  of  mention  because  it  is 
advocated  by  several  accountants.  This  is  very  similar  to 
the  compound  interest  method.  The  difference  consists  in 
adding  to  the  compound  interest  charge  an  amount  to  cover 
•interest  on  the  book  value.  This  additional  amount  is  charged 
to  the  Depreciation  Expense  account  but  is  credited  to  Interest 
instead  of  Allowance  for  Depreciation.  The  following  table 
will  serve  to  make  the  method  clear.  This  represents  the  book 
value,  interest  on  the  book  value,  depreciation,  and  the  expense 
charge  for  each  year  in  the  case  of  a  machine  which  costs  $100, 
will  last  ten  years,  and  has  a  salvage  value  of  $5.  The 
interest  rate  of  five  per  cent  is  used  in  the  computation. 
Column  (4)  shows  the  net  depreciation,  which  corresponds  to  the 
charge  under  the  compound  interest  method ;  column  (3)  shows 
the  interest  on  the  book  value  for  each  year,  and  column  (5) 
shows  the  amount  charged  to  Depreciation  Expense,  the  sum  of 
the  items  in  columns  (3)  and  (4). 


526 


PRINCIPLES  OF  ACCOUNTING 


(l) 

YEAR 

(2) 

BOOK  VALUE 
BEGINNING  OF  YEAR 

(3) 
INTEREST  ON  BOOK 
VALUE 

(4) 

NET 
DEPRECIATION 

(5) 
EXPENSE  CHARGE 
<3)+U) 

I 

$IOO.OO 

$5-00 

$7-55 

$12.55 

2 

92.45 

4.62 

7-93 

12-55 

3 

84.52 

4.22 

8-33 

12.55 

4 

76.19 

•     3-8l 

8.74 

12-55 

5 

67-45 

3-37 

9.18 

12-55 

6 

58.27 

2.91 

9.64 

12-55 

7 

48.63 

2-43 

IO.I2 

12-55 

8 

38.51 

1.92 

10.63 

12.55 

9 

27.88 

i-39 

ii.  16 

12.55 

10 

16.72 

•83 

11.72 

12-55 

Total  .     . 

$3O.  sO 

$nc.OO 

$i2S  so 

The  journal  entries  for  the  first  year  would  be, 

Depreciation  Expense $12.55 

Allowance  for  Depreciation     ...  $7-55 

Interest 5.00 

Each  succeeding  year,  the  entries  would  be  the  same  in  form, 
the  debit  to  Depreciation  Expense  always  being  $12.55  (hence 
the  name  annuity  method),  the  amount  in  column  (4)  being 
credited  to  Allowance  for  Depreciation,  and  the  amount  in 
column  (3)  to  Interest.  It  may  easily  be  seen  that  the  net 
effect  of  this  method  on  the  available  net  revenue  and  also  on 
book  value  is  the  same  as  under  the  compound  interest  method.  • 
There  is  a  fundamental  error  involved  in  the  plan,  however,  and 
that  is  in  including  interest  on  invested  capital  in  the  expense  ac- 
counts. The  amount  in  column  (3)  is  charged  to  expense  and 
immediately  credited  as  a  net  revenue  item.  It  represents  the 
services  of  the  equities  in  investing  these  funds  in  machinery. 
To  consider  such  services  as  expenses  in  the  accounts  is,  as  has 
been  shown  before,  an  illogical  procedure. 

Several  other  rather  arbitrary  methods  have  been  devised  for 
spreading  depreciation  on  what  is  supposed  to  correspond  to  the 
ability  of  the  revenue  to  stand  the  charge.  One  of  these  is  the 
fixed  percentage  of  declining  value  method.  A  percentage  figure 
is  found  which  applied  consecutively  to  book  value  at  the  begin- 


METHODS  OF  MEASURING  DEPRECIATION  527 

ning  of  each  year  will  reduce  that  figure  from  cost  to  salvage 
value  during  the  service  life.  The  charges  during  the  first  years 
are  large  but  the  amount  continually  decreases  until  the  last 
year,  as  it  is  supposed  that  revenues  can  stand  heavy  charges 
during  the  early  years  and  lighter  ones  during  later  years.  Very 
little  can  be  said  for  this  method,  since  revenue  should  not  be. a 
controlling  factor  in  fixing  depreciation  charges  as  has  been 
shown  before. 

A  further  discussion  of  different  methods  would  be  out  of 
place  in  this  text.  Those  given  serve  to  illustrate  the  diver- 
gence of  practice ;  and,  as  was  stated  earlier,  the  methods 
described  in  the  preceding  sections  are  adequate  for  all  cases. 
The  particular  conditions  which  make  one  or  another  form 
advisable  were  stated  in  the  different  sections. 


XXIV 

THE  INTANGIBLE  ASSETS 

THE  point  has  been  emphasized  repeatedly  in  the  preceding 
pages  that  property  is  a  category  which  includes  both  material 
and  immaterial  items.  It  has  been  shown  further  that  another 
important  line  of  division  groups  all  properties  into  fixed  assets 
and  current  assets.  Such  items  as  prepaid  insurance  or  similar 
deferred  assets,  and  rights  such  as  accounts  receivable,  are 
examples  of  current  immaterial  assets.  Current  assets  of  all 
types  furnish  less  difficult  problems  of  valuation  than  arise  in  the 
case  of  the  fixed  assets  as  has  been  explained.  The  treatment  of 
current  intangibles  has  already  been  sufficiently  discussed,  and 
the  valuation  of  long-term  rights  such  as  bonds  and  similar 
securities  was  quite  fully  considered  in  Chapter  XVIII.  Thus 
far  little  attention  has  been  given,  however,  to  the  fixed  in- 
tangibles proper  —  goodwill,  going  value,  patents,  etc.  In  the 
present  chapter  the  nature  and  treatment  of  these  assets  will  be 
discussed. 

THE   NATURE    OF   GOODWILL 

The  rates  of  return  realized  on  the  capital  invested  in  pro- 
duction vary  widely  between  different  enterprises,  —  even  in 
the  same  industry.  In  the  manufacture  of  furniture,  for  example, 
one  firm  will  be  earning  five  per  cent  on  the  investment,  another 
six  per  cent,  still  another  ten  per  cent,  and  so  on.  The  conditions 
leading  to  business  success  are  very  complex,  and  hence  it  should 
be  recognized  that  the  amount  of  capital  invested  in  any  case  is 
only  one  of  the  elements  determining  the  amount  of  net  revenue. 
Managerial  ability,  methods  and  processes,  territorial  location, 
trade  name,  selling  organization  —  these  and  many  other 
factors  contribute  to  financial  success.  Some  enterprises 

528 


THE  INTANGIBLE  ASSETS  529 

possess  a  superior  equipment  as  compared  with  their  competitors 
in  regard  to  such  factors.  Such  enterprises  may  be  said  to  have 
goodwill.  Goodwill  may  then  be  defined  as  the  capitalized  value 
of  the  excess  income  which  a  particular  firm,  because  of  greater 
efficiency  or  any  monopolistic  advantages,  is  able  to  realize 
over  a  normal  enterprise  in  the  same  industry  and  having  the 
same  capital  investment.  By  a  normal  enterprise  is  meant  an 
enterprise  that  is  earning  a  rate  of  return  high  enough  to  attract 
a  proper  flow  of  capital  to  the  industry  in  question. 

It  may  be  assumed,  for  example,  that  the  A  Co.  has  $1,000,000 
of  capital  invested,  and  earns  a  net  revenue  of  $80,000  per  year. 
This  gives  a  rate  of  eight  per  cent  on  the  investment,  which, 
it  will  be  supposed,  is  the  rate  of  return  necessary  to  attract  the 
investor  to  this  field  of  production.  The  B  Co.  has  also  invested 
$1,000,000  in  the  same  industry  but  earns  $160,000  annually, 
giving  a  rate  of  sixteen  per  cent.  Now  it  is  evident  that  the 
property  of  the  B  Co.,  because  of  all  the  conditions  that  go  with 
it,  is  worth  twice  as  much  from  the  standpoint  of  a  prospective 
investor  as  the  property  of  the  A  Co. ;  for  the  final  test  of  the 
value  of  any  property  from  this  standpoint  is  its  earning  power. 
The  original  investment  is  the  same  in  both  cases,  but  the  advan- 
tages of  the  B  Co.  are  such  that  it  possesses  twice  the  earning 
power  of  the  other  company.  (Permanence  of  income,  conditions 
of  risk,  etc.,  are  also  assumed  to  be  the  same  in  both  cases.) 
The  B  Co.  may  then  be  said  to  have  an  intangible  asset  due  to 
one  or  more  factors  that  give  it  an  advantage  over  the  normal 
enterprise.  Goodwill  might  be  again  defined,  then,  as  the 
capitalization  of  a  differential  profit  which  a  particular  enterprise 
enjoys. 

Defined  thus  broadly  goodwill  includes  the  value  of  all  such 
intangibles  as  patents,  copyrights,  trademarks,  franchises,  etc. 
Where  such  definite  items  exist,  however,  it  may  be  desirable 
to  restrict  goodwill  to  the  value  of  the  more  general  monopolistic 
advantages  such  as  location,  and  of  the  peculiar  efficiency  or 
prestige  attaching  to  the  particular  enterprise.  Illegitimate 
practices  in  restraint  of  trade  may  evidently  lead  to  a  large 
intangible  item  which  might  be  considered  a  kind  of  goodwill. 

An  exceptional  rate  of  income  permanently  assured  is  not 
essential  to  the  origin  of  goodwill.  The  assurance  of  huge  earn- 
in 


530  PRINCIPLES  OF  ACCOUNTING 

ings  for  a  few  years,  or  even  a  single  year,  adds  to  the  value  of 
the  property  involved. 

Goodwill  is  often  transferable,  as  is  any  asset.  In  some  cases, 
however,  goodwill  is  dependent  upon  the  personnel  of  the  pro- 
prietors. In  such  a  case  this  asset  measures  the  capital  value 
of  the  business  qualities  and  characteristics  of  a  certain  individual 
or  group  of  individuals  attached  to  a  business  enterprise.  This 
situation  occurs  most  frequently  in  sole-proprietor  enterprises 
and  in  partnerships.  The  proprietors  in  such  a  case  often  give  a 
value  to  their  firm  because  of  the  personal  esteem  with  which 
they  are  regarded  by  their  customers.  Or  the  business  may  be 
one  which  requires  peculiar  skill,  in  which  case  the  success  of 
the  enterprise  depends  largely  upon  the  knowledge  of  the  business 
which  the  original  owners  possess.  In  all  such  cases  it  is  not 
possible  to  transfer  goodwill  from  one  business  to  another 
unless  the  change  is  nominal  as  far  as  the  personnel  of  the 
owners  is  concerned.  When,  however,  goodwill  depends  upon  a 
trade  name,  a  copyright,  market  conditions,  secret  processes, 
etc.,  it  is  usually  possible  to  transfer  the  asset  from  one  enterprise 
to  another. 

It  is  evident  that  the  exact  determination  of  the  amount  of 
goodwill  in  a  particular  case  may  be  a  matter  of  considerable 
difficulty.  The  definition  given  above  involves  the  ascertaining 
of  the  normal  competitive  rate  of  income  in  the  industry  in 
question  and  the  number  of  years  during  which  the  excess  income 
can  be  expected  to  accrue.  Whenever  goodwill  is  purchased, 
however,  such  valuations  are  actually  made.  The  difficulty 
of  setting  a  reasonable  value  upon  goodwill  outside  of  an  actual 
transaction  is  one  reason  for  the  prejudice  against  the  recognition 
of  this  asset  except  as  purchased.  The  problems  of  valuation 
arising  in  connection  with  goodwill  will  be  considered  in  the  next 
section. 

THE   VALUATION   OF   GOODWILL 

Although  according  to  the  definition  given  in  the  preceding 
section  goodwill  as  an  economic  fact  may  originate  without  cost, 
it  is  not  considered  good  practice  to  recognize  this  asset  in  the 
accounts  unless  it  is  purchased.  This  may  seem  at  first  sight  an 
unreasonable  view,  but  it  is  consistent  with  the  principles  of 


THE  INTANGIBLE  ASSETS  531 

valuation  developed  in  preceding  chapters.  Goodwill,  as  has 
been  explained,  is  based  upon  an  unusual  rate  of  income.  It  is 
the  capitalization  of  the  peculiar  advantages  which  a  particular 
firm  enjoys.  If  goodwill  were  generally  recognized  as  an  asset 
in  the  accounts  of  all  enterprises  in  a  given  industry  there  would 
be  no  unusual  rates  of  return.  The  most  successful  firm  would 
earn  no  more  than  the  ordinary  competitive  rate  of  return.  As 
regards  income  rates  all  supra-marginal  enterprises  would  be 
reduced  to  the  level  of  the  marginal  business.  The  actual 
situation  would  seem  to  be  obscured  by  such  a  practice. 

To  capitalize  an  excess  earning  power  and  enter  the  result 
in  the  books  as  an  asset  would  be  a  practice  similar  to  the  rec- 
ognition of  interest  accruing  during  construction.  The  objections 
already  made  to  such  a  procedure  can  be  applied  with  equal 
force  to  the  capitalization  of  unusual  earning  power.  Such  a 
practice  again  means  the  accruing  of  the  services  furnished  by  the 
owners  themselves  (or  the  peculiar  advantages  possessed  by  the 
owners)  as  an  asset.  This,  it  has  been  insisted,  is  not  the 
function  of  the  accounts.  The  accounts  should  follow  the  actual 
investment  of  the  owners  as  it  takes  shape  in  various  commodities 
and  services  purchased,  but  should  not  show  the  capitalization  of 
the  peculiar  functions  and  advantages  inhering  in  the  particular 
enterprise  itself.  The  actual  rate  of  return  is  the  significant 
fact  for  the  proprietor.  He  wishes  to  know  just  what  the  capital 
fund  in  his  possession  is  yielding,  and  if  the  rate  is  reduced  to  a 
nominal  level  by  the  capitalization  of  a  part  of  income  the  actual 
situation  is  covered  up. 

This  view  is  not  inconsistent  in  any  way  with  the  theory  that 
changes  marketwise  in  the  assets  owned  by  an  enterprise  should 
be  followed  in  the  accounts.  The  recognition  of  depreciation 
and  appreciation  makes  the  capital  accounts  conform  to  the 
actual  situation,  and  accounting  for  appreciation  should  not 
be  confused  with  the  capitalization  of  income.  If  the  accounts 
are  to  present  a  correct  showing  of  invested  capital  (actual  assets 
donated  included)  and  thus  give  the  manager  a  basis  for  judg- 
ments in  connection  with  the  proper  utilization  of  resources, 
all  value  changes  must  be  recognized  as  far  as  this  is  practicable. 
But  capitalized  income  is  not  an  asset  value  in  this  sense.  As 
was  emphasized  in  Chapter  XX  and  elsewhere  the  accounts 


532  PRINCIPLES  OF  ACCOUNTING 

should  show  the  investor  the  actual  rate  of  return  realized  on  the 
economic  resources  possessed  by  the  enterprise.  If  this  rate  is 
twenty  per  cent  in  a  particular  year  the  asset  accounts  should  be 
consistent  with  this  fact.  If  the  rate  is  ten  per  cent  the  accounts 
should  conform  to  the  actual  situation.  Accounting  which 
attempts  to  iron  out  the  fluctuations  in  net  revenue  in  a  particular 
enterprise,  or  to  reduce  the  rates  realized  by  different  enterprises 
to  the  same  level,  if  not  actually  improper,  is  at  least  not  to  be 
commended. 

If,  on  the  other  hand,  a  particular  enterprise  buys  the  assets 
of  another  company  and  pays  something  in  excess  of  the  value 
of  its  plant  and  equipment  in  order  to  secure  certain  advantages 
which  give  an  exceptional  earning  power,  in  this  case  an  invest- 
ment is  actually  made  in  goodwill  and  it  becomes  an  intangible 
asset  on  the  books  of  the  purchaser.  It  may  seem  that  this 
shifts  the  basis  of  valuation,  but  this  is  not  really  the  case.  As 
was  explained  in  Chapter  XIX  an  enterprise  which  invests 
$100,000  in  the  construction  of  a  plant  has  a  property  which 
should  be  entered  in  the  accounts  at  that  figure.  If  at  the 
end  of  the  construction  period  the  completed  plant  is  sold  to 
another  company  for  $106,000,  the  new  company  should  value 
the  property  at  $106,000,  for  it  has  purchased  the  service  of  the 
construction  company.  But  this  does  not  justify  the  capitaliza- 
tion of  the  construction  company's  service  in  its  own  accounts. 
Similarly  an  enterprise  which  because  of  exceptional  advantages 
earns  a  very  high  rate  of  return  is  not  justified  in  capitalizing  a 
part  of  that  return  even  though  it  may  be  possible  to  dispose  of 
these  advantages  at  a  price  under  certain  conditions. 

It  is  not  intended  to  deny  the  importance  of  the  capitalization 
process  as  an  economic  fact  but  it  does  not  seem  reasonable  or 
practicable  to  capitalize  in  the  accounts  of  an  enterprise  any 
part  of  its  income. 

Goodwill  is  frequently  made  use  of  in  accounting  practice  to 
validate  security  issues.  Often  the  par  value  of  the  securities 
issued  exceeds  the  actual  value  of  the  property  acquired.  In  such 
cases  it  is  common  practice  to  label  the  amount  of  the  discrepancy 
goodwill.  This  practice  iS  evidently  improper,  for  the  goodwill 
in  such  a  case  is  entirely  fictitious.  As  was  stated  in  a  preceding 
chapter  discount  on  stock  should  be  used  to  represent  the  excess 


THE  INTANGIBLE  ASSETS  533 

of  the  par  value  of  stock  and  other  securities  issued  over  the 
value  of  the  property  acquired.  Frequently  some  general  title 
such  as  ''property,  goodwill,  royalties,  etc.,"  is  used  on  the 
balance  sheet.  This  is  still  more  questionable,  for  such  a  heading 
does  not  show  even  the  estimated  amount  of  goodwill. 

Often  when  a  partnership  or  corporation  is  taken  over  by 
another  concern,  something  is  paid  for  goodwill,  even  though 
this  asset  has  not  been  previously  recognized  on  the  books  of  the 
original  concern.  If  actual  property  is  paid  for  this  asset, 
then  it  is  entirely  proper  to  list  it  on  the  books  of  the  buyer 
(especially  if  the  purchase  took  place  under  competitive  con- 
ditions) ;  but  it  should  be  recorded  in  a  distinct  account  and  for 
the  amount  actually  paid.  Very  often  the  payment  made  is  in 
securities  with  only  a  nominal  value,  and  hence  the  goodwill  is 
fictitious. 

The  later  treatment  of  goodwill  in  the  accounts  raises  some 
interesting  questions.  If  the  special  advantages  purchased  are 
permanent  the  asset  goodwill  evidently  need  not  be  depreciated. 
Peculiar  efficiency  and  monopolistic  advantages,  however,  are 
seldom  permanent  factors  and  hence  the  problem  of  depreciating 
goodwill  arises  in  most  cases.  When  the  advantages  purchased 
disappear,  goodwill  should  be  written  down.  If  goodwill  is 
based  upon  definite  terminable  rights  such  as  leases  or  patents 
it  should  be  amortized  during  the  life  of  these  rights.  Such 
rights  are  not  goodwill  in  a  strict  sense,  however,  and  will  be 
further  considered  in  a  later  section  of  this  chapter. 

If  a  decline  in  income  is  expected,  and  occurs  because  of  the 
decay  of  physical  property  or  because  some  condition  or  privilege 
upon  which  goodwill  depends  covers  a  definite  period  of  years, 
then  goodwill  can  be  amortized  as  is  any  asset  by  depreciation 
charges  against  revenue  based  upon  some  appropriate  method  of 
apportionment.  It  is  sometimes  objected  that  it  is  unreasonable 
to  write  off  goodwill  when  revenues  are  declining  as  this  further 
impairs  net  revenue,  and  that  goodwill  accordingly  should  be 
charged  against  revenues  in  boom  years  or  against  accumulated 
surplus  as  rapidly  as  possible.  Such  a  practice  can  hardly  be 
commended.  Certainly  the  logical  position  to  take  is  that  the 
accounts  should  express  as  nearly  as  possible  the  actual  situation. 
Goodwill  should  not  be  left  on  the  books  when  it  is  known  that  the 


534  PRINCIPLES  OF  ACCOUNTING 

asset  no  longer  exists,  and  it  need  not  be  amortized  unless  depre- 
ciation actually  occurs. 

To  be  consistent  with  the  view  that  goodwill  should  not 
be  recognized  unless  purchased  it  should  be  insisted  that  goodwill 
can  never  appreciate.  Any  added  earning  power  over  and 
above  the  return  secured  by  the  original  purchase  of  goodwill  is 
due  to  the  peculiar  efficiency  or  other  advantages  possessed  by 
the  new  enterprise  and  should  be  reflected  by  a  higher  rate  on 
the  investment,  and  not  by  charges  to  the  asset  accounts. 

The  peculiar  advantages  which  one  enterprise  possesses  as 
compared  with  another  are  reflected  more  or  less  accurately  in  the 
market  price  of  its  securities.  The  prices  of  stocks  and  bonds 
are  naturally  based  to  a  considerable  extent  upon  market  income 
rates.  The  selling  price  of  the  stock  of  a  metropolitan  newspaper 
company,  for  example,  may  be  far  above  the  book  value  of  the 
stock.  The  balance  sheet  of  the  B  Co.,  for  example,  appears  as 
follows : 

Property $1,250,000      Capital  Stock .    .    .    .    $1,000,000 

Surplus 250,000 


$1,250,000  $1,250,000 

The  par  of  the  B  Co.'s  stock  is  $100  and  the  book  value  is  $125 
per  share.  Total  proprietorship  as  shown  by  the  accounts  is 
then  $1,250,00x3.  On  the  market,  it  will  be  assumed,  this  stock 
sells  for  $200  per  share.  According  to  the  market  valuation 
proprietorship  amounts  to  $2,000,000.  The  difference  of 
$750,000  between  the  two  valuations  may  be  called  goodwill. 
If  the  balance  sheet  were  revised  by  the  recognition  of  this  in- 
tangible it  might  appear  as  follows : 

Property $1,250,000      Capital  Stock      .     .     .  $1,000,000 

Goodwill 750,000      Surplus 250,000 

Goodwill  Surplus     .     .  750,000 

$2,000,000  $2,000,000 

As  has  been  explained,  however,  no  purpose  is  served  by  the 
recognition  in  the  accounts  of  security  prices  or  any  phase 
of  goodwill  unless  the  item  has  been  purchased. 


THE  INTANGIBLE  ASSETS  535 

GOING  VALUE 

The  interval  from  the  time  a  business  enterprise  is  originally 
projected  to  the  time  the  firm  begins  to  earn  a  normal  return  on 
the  investment  may  be  divided  into  two  periods  :  (i)  the  period 
extending  from  the  time  the  first  steps  by  the  promoter  are  taken 
to  the  time  when  the  concern  begins  to  earn  revenue ;  (2)  the 
period  extending  from  the  time  when  revenue  first  accrues  to  the 
time  when  a  normal  return  on  the  investment  is  realized.  The 
first  period  constitutes  the  organization  and  construction  period 
and  is  common  to  all  enterprises ;  while  the  second  represents 
the  pioneering  or  experimental  period  and  does  not  confront 
all  new  enterprises  in  old  established  lines.  The  distinction 
between  the  two  periods  cannot  always  be  sharply  drawn,  but 
it  is  an  important  general  distinction  to  be  kept  in  mind  in 
analyzing  the  nature  of  going  value. 

It  was  explained  in  Chapter  XIX  that  the  costs  of  promotion, 
incorporation  fees,  underwriters'  charges,  costs  of  preliminary 
advertising,  etc.,  are  all  outlays  essential  to  the  finished  plant 
and  organization,  ready  for  operation.  Such  charges  are  as 
legitimate  capital  outlays  as  the  cost  of  labor  and  materials 
entering  directly  into  the  tangible  property  items.  These  items 
are  a  necessary  cost  of  property  and  are  intangible  only  in  that 
it  is  not  convenient  to  allocate  them  to  specific  tangible  units 
although  they  are  incident  to  the  property  as  a  whole.  Going 
value,  if  used  to  express  the  sum  total  of  general  organization  and 
construction  costs,  is  a  bona  fide  asset. 

Going  value,1  however,  is  more  commonly  used  to  express  the 
capitalized  value  of  early  capital  losses  and  unrealized  income. 
In  the  development  of  a  new  enterprise  a  considerable  interval 
often  elapses  between  the  time  that  revenue  actually  begins  to 
accrue  and  the  time  that  a  normal  rate  of  income  is  earned. 
Sometimes  the  wheels  have  been  turning  for  several  years  follow- 
ing the  completion  of  the  plant  before  the  business  is  put  upon  a 
paying  basis.  This  is  particularly  true  of  industries  in  what 
might  be  called  the  experimental  stage.  Many  of  the  electric 
power  companies,  for  example,  failed  to  realize  a  normal  rate 

1  Developmental  value,  pioneering  value,  experimental  value,  and  going 
value  are  expressions  which  are  used  more  or  less  synonymously. 


536  PRINCIPLES  OF  ACCOUNTING 

of  net  revenue  in  the  early  years  of  the  industry ;  and  in  some 
cases  actual  capital  losses  were  suffered.  This  was  due  to  the 
lack  of  a  brisk  demand  for  the  product,  to  the  rapidity  of  mechani- 
cal changes  in  equipment,  and  to  the  high  costs  due  to 
inexperienced  management.  On  the  theory  that  the  investor  is 
entitled  to  a  fair  return  on  his  investment  it  has  been  urged  that 
there  is,  in  such  cases,  a  developmental  or  going  value  represent- 
ing the  capitalization  of  the  early  losses  of  the  enterprise. 

This  theory  is  of  significance  primarily  in  connection  with  the 
regulation  of  the  rates  of  public  utilities.  The  problem  in  such 
cases  is  so  to  adjust  prices  that  the  investor  in  such  properties 
will  neither  be  discriminated  against  nor  advantaged  as  compared 
with  his  fellow  investor  in  competitive  lines  which  involve  the 
same  burdens  as  regards  risk  and  other  aspects  of  ownership. 
If  the  investor  in  competitive  lines  is  able  to  recover  pioneering 
losses,  then  the  investor  in  public  utilities  should  be  allowed  to 
do  so.  It  is  doubtful,  however,  if  in  competitive  enterprises 
the  investor  is  always  able  to  recompense  himself  for  early  losses 
in  later  higher  prices.  If  all  investors  in  a  certain  industry 
suffered  losses  (or  did  not  realize  the  normal  return  afforded  by 
general  business)  for  a  given  period,  it  might  seem  reasonable  to 
conclude  that  prices  would  later  be  high  enough  to  cover  the 
early  losses.  Even  in  such  a  case  this  conclusion  is  questionable. 
Once  the  industry  in  question  becomes  established  can  the  early 
investors  charge  higher  prices  because  of  previous  losses? 
Would  not  capital  flow  from  other  lines  into  the  now  established 
industry  and  drive  prices  down  to  a  point  at  which  a  normal 
return  was  realized?  There  is  no  definite  assurance  in  the 
market  situation  that  the  investor  in  the  specific  enterprise 
will  be  able  to  recoup  early  losses  in  later  prosperous  years. 
One  enterprise  may  prove  ultimately  successful  while  another 
enterprise  may  never  yield  a  fair  return.  It  is  a  familiar  fact 
that  in  certain  hazardous  lines  more  capital  is  dissipated  in 
unsuccessful  ventures  than  is  earned  by  successful  companies. 
In  other  words  from  the  standpoint  of  capital  return  the  industry 
as  a  whole  in  such  a  case  is  operating  at  a  net  loss. 

Business  losses  whether  due  to  experiments,  changes  in  demand, 
inefficiency,  or  to  any  other  cause,  cannot  be  recovered  by  the 
specific  enterprise  bearing  such  losses  (unless  monopolistic 


THE  INTANGIBLE  ASSETS  537 

conditions  prevail).  These  are  among  the  risks  of  ownership 
which  require  at  least  the  prospect  of  net  revenue  to  attract 
capital.  Net  revenue  in  general,  it  is  true,  is  the  economic 
burden  which  the  community  bears  to  secure  the  services  of 
ownership.  The  possibility  of  losses  during  the  developmental 
period  or  of  ultimate  failure  is  one  of  the  reasons  for  the  existence 
of  a  net  return  to  the  owners  in  prices.  But  net  revenue  is  not 
guaranteed  in  all  cases ;  and  if  it  were  one  of  the  reasons  for  the 
existence  of  the  residuum  over  expense  charges  would  be  de- 
stroyed. 

Even  if  it  were  true  that  the  normal  competitive  enterprise 
is  able  to  realize  an  income  in  later  years  sufficient  to  offset  the 
early  lean  years  this  would  not  be  an  adequate  reason  for 
capitalizing  early  losses  and  entering  the  result  as  an  intangible 
asset  in  the  accounts.  This  would  simply  be  the  capitalization 
of  a  phase  of  income  and  is  open  to  the  same  objections  already 
urged  against  the  recognition  of  goodwill  (unless  purchased) 
and  interest  during  construction.  The  capital  funds  of  the 
enterprise  are  not  accruing  each  year  at  the  normal  competitive 
rate  of  interest.  It  is  true  that  the  investor  hopes  to  realize  a 
sufficiently  high  rate  later  to  make  up  for  the  lean  periods,  but 
even  if  the  large  earnings  are  definitely  assured  would  it  not 
obscure  the  actual  situation  to  capitalize  the  earnings  when  still 
unrealized  ?  All  such  accounting,  as  previously  explained,  tends 
toward  the  elimination  of  the  fluctuations  in  the  rate  of  in- 
come. 

In  certain  cases  of  publicly  regulated  enterprises,  however, 
such  an  intangible  asset  may  with  reason  be  allowed.  The 
determination  of  a  fair  rate  of  income  is  the  important  question 
in  such  cases.  If  the  rates  prescribed  by  law  have  been  lower 
than  the  rates  which  would  have  normally  been  earned,  or  if 
the  investor  is  restricted,  in  other  words,  to  a  non-speculative 
rate  of  return,  then  he  should  be  allowed  to  recover  early  losses 
in  later  higher  prices.  One  way  of  accomplishing  this  end  is  to 
allow  the  company  to  charge  its  customers  prices  which  will 
yield  a  fair  return  not  only  on  actual  investment  but  upon 
capitalized  losses  and  unrealized  income  as  well.  Even  in  such 
a  case,  however,  the  matter  is  a  question  for  judicial  as  well  as 
accounting  opinion.  There  seems  to  be  sufficient  ground  for 


538  PRINCIPLES  OF  ACCOUNTING 

excluding   developmental   value   from   the   accounts   with   the 
possible  exception  of  this  case. 


MISCELLANEOUS   INTANGIBLES 

There  are  a  number  of  specific  conditions  and  rights  which 
give  rise  to  important  intangible  assets.  Some  of  these  assets 
can  be  included  under  the  general  head,  goodwill ;  but  it  usually 
is  more  desirable  to  use  a  distinct  account  for  each  asset.  A 
brief  discussion  of  a  few  of  the  more  important  examples  will  be 
given  in  this  section. 

Special  privileges  granted  by  the  state  to  specific  enterprises 
often  give  rise  to  exceptional  earning  power  and  hence  have  an 
important  value.  Of  these  privileges  the  patent  right  is  the 
most  important.  A  patent  is  a  grant  by  the  state  conferring 
exclusive  privileges  for  a  specified  length  of  time  in  connection 
with  the  production  and  sale  of  some  product  or  exclusive  right 
to  some  method  or  process  of  production.  It  gives  to  the 
grantee  a  monopoly  in  the  manufacture  and  sale  of  some  inven- 
tion or  in  the  use  of  some  device.  The  real  test  as  to  whether 
a  patent  has  value  or  not  is  not  its  cost  but  its  earning  power  as 
in  the  case  of  any  fixed  intangible.  It  is  considered  advisable, 
however,  to  enter  a  patent  on  the  books  at  the  cost  of  the  experi- 
ments that  gave  rise  to  it,  and  the  clerical  fees  necessary  to 
secure  it,  in  anticipation  of  the  financial  success  of  the  device 
involved.  When  a  corporation  organizes  and  buys  out  an  in- 
vention, for  example,  the  patent  right  is  entered  at  the  purchase 
price.  If  the  sale  has  been  a  bona  fide  transaction  on  a  cash  or 
an  equivalent  basis  the  success  of  the  invention  is  usually  reason- 
ably assured,  and  the  price  paid  is  the  capitalized  value  of  the 
expected  earning  power. 

Until  the  success  of  the  enterprise  has  been  actually  tested  it 
would  seem  somewhat  unreasonable  to  list  patents  as  an  asset 
at  anything  above  cost.  There  is  less  reason  for  objecting  to 
the  recognition  of  patent  rights  at  actual  market  value,  however, 
than  to  the  entry  of  goodwill  due  to  peculiar  prestige  and  effi- 
ciency. A  patent  right  is  a  definite  possession,  often  highly 
marketable,  and  to  capitalize  its  earning  power  in  the  accounts 
would  not  mean  in  any  sense  the  accruing  of  the  services  or 


THE  INTANGIBLE  ASSETS  539 

personal  advantages  of  the  proprietors  as  an  asset.  If  a  patent 
right  comes  to  be  worth  a  large  amount  although  costing  practi- 
cally nothing  there  is  no  very  substantial  objection  to  its  rec- 
ognition at  a  conservative  valuation.  A  firm,  for  example, 
may  own  no  other  property  than  a  patent  right  which  cost  but  a 
nominal  sum  and  yet  the  lease  of  this  right  to  other  parties  may 
give  rise  to  a  considerable  income.  It  would  be  entirely  legiti- 
mate in  such  a  case  to  consider  as  an  asset  either  the  patent  right 
or  the  contracts  based  upon  this  right. 

Patents  are  often  used  as  an  asset  at  organization  to  validate 
large  issues  of  securities.  If  the  success  of  the  patent  is  reason- 
ably assured  this  practice  can  be  justified.  But  hundreds  of 
patents  are  taken  out  which  never  become  the  basis  of  profit- 
able enterprises.  The  real  value  of  a  patent  depends  upon 
the  earring  power  which  it  gives  to  an  enterprise,  and  it  is  when 
this  earning  power  is  known  or  assured  that  it  can  properly  be 
considered  as  an  asset. 

Since  patents  are  terminable  rights  such  assets  should  be 
amortized  during  the  life  of  the  privilege  in  any  case.  Patents 
run  for  various  terms  of  years.  A  mechanical  patent  runs  for 
seventeen  years  in  the  United  States  and  can  be  renewed  under 
certain  conditions.  In  the  amortization  of  patents  earning  power 
and  length  of  life  are  the  important  elements  to  be  considered. 
If  the  rate  of  return  realized  falls  because  of  other  improvements 
such  assets  should  be  depreciated  even  if  the  privilege  involved 
has  not  legally  expired.  When  income  can  be  determined  in 
advance  with  reasonable  accuracy  a  patent  may  be  amortized 
by  the  present  value  of  future  revenue  method. 

Trademark  and  copyright  privileges  give  rise  to  assets  similar 
to  patent  values. 

Another  class  of  intangible  assets  is  based  upon  leases  and 
similar  private  contracts.  These  assets  are  more  definite  in 
character  than  most  intangibles.  Suppose,  for  example,  that 
the  owner  of  a  mining  property  leases  this  property  to  an 
operating  company  for  fifty  years,  the  annual  consideration 
being  $5,ooo.1  The  lease  contract  would  represent  an  asset  to 
the  lessor  similar  to  an  annuity.  The  value  of  fifty  annual  sums 

1  For  convenience  it  will  be  assumed  that  at  the  end  of  fifty  years  the  value 
of  the  property  will  be  exhausted. 


540  PRINCIPLES  OF  ACCOUNTING 

of  $5,000  each  on  a  six  per  cent  basis  is  $78,809-30.  Such  a 
lease  amounts  virtually  to  a  sale  and  the  value  of  the  lease  may 
now  appear  on  the  lessor's  books  rather  than  the  mining  prop- 
erty. The  balance  sheet  of  the  lessor  with  respect  to  this 
single  item  would  appear  somewhat  as  follows  : 

Lease $78,809.30      Lessor,  Proprietor    .     .     $78,809.30 

The  value  of  the  lease  should  be  amortized  by  the  present  value 
of  future  revenue  method.  The  entries  recognizing  the  item  of 
depreciation  for  the  first  year  would  be : 

Lease  Depreciation $271.44 

Lease  (or  Reserve  for  Depreciation)  $271.44 

(The  amount  of  depreciation  may  conveniently  be  found  by 
subtracting  six  per  cent  of  $78,809.30  from  the  amount  of  the 
annual  payment.)  When  the  annual  rent  is  received  the  entries 
would  be  as  follows : 

Cash $5,ooo 

Rent $5,000 

The  gross  revenue  appearing  in  the  Rent  account  less  the  item 
of  depreciation  gives  $4,728.56,  or  six  per  cent  on  the  original 
lease  value.1 

Where  the  lessee  pays  a  lump  sum  in  advance  a  somewhat 
different  intangible  asset  arises  on  the  books  of  the  lessee. 
The  amount  of  the  prepayment  is  an  asset  since  the  service 
purchased  will  not  be  exhausted  for  several  fiscal  periods.  Such 
an  asset  is  another  illustration  of  the  deferred  debit  discussed  in 
Chapter  X.  Suppose  a  railroad  company,  for  example,  leases 
the  road  of  a  small  line  for  ten  years,  paying  for  the  lease  a  lump 
sum  of  $250,000.  The  expenditure  would  be  entered  as  follows  : 

Lease $250,000 

Cash $250,000 

1  The  entries  in  this  case  might  evidently  be  contracted  to  the  following : 

Cash $5,000 

Lease $    271.44 

Net  Revenue 4,728.56 


THE  INTANGIBLE  ASSETS  541 

Each  year  a  portion  of  the  original  payment  would  be  considered 
an  expense.  If  the  asset  were  amortized  according  to  the  com- 
pound interest  method  at  six  per  cent  the  entries  for  the  first 
year  would  be : 

Depreciation  Expense     ....    $18,966.99 

Lease  (or  Reserve  for  Depreciation)  $18,966.99 

In  certain  cases  it  might  be  urged  that  a  lease  constitutes  an 
asset  on  the  books  of  the  lessee  even  when  the  consideration  is 
an  annual  payment.  Thus  the  lessee  in  the  last  case  above 
mentioned  might  consider  the  right  to  use  the  leased  property 
of  considerable  "strategic  value,"  and  hence  deem  the  contract 
an  asset.  If  such  a  lease  weie  entered  as  an  asset  when  no  outlay 
is  involved,  the  concurrent  credit  would  necessarily  be  to  Surplus 
or  some  proprietary  account.  Such  a  situation  would  be  un- 
likely except  in  the  case  of  small  railroad  lines  and  similar  prop- 
erties where  the  location  of  the  leased  property  is  such  that  it 
has  little  value  for  more  than  one  enterprise.  In  such  cases 
competitive  bidding  for  the  property  is  lacking  and  the  service 
may  be  secured  for  less  than  its  real  value. 

Whenever  a  franchise  or  charter  granted  by  the  state  to  a 
public  utility  enterprise  gives  to  that  firm  monopolistic  privileges, 
the  franchise  gives  rise  to  an  intangible  asset.  Its  value  depends 
upon  the  extent  to  which  the  company's  earning  power  is  in- 
creased by  such  exclusive  privileges ;  and,  as  in  the  case  of  any 
similar  intangible,  the  ascertaining  of  that  value  may  be  a  diffi- 
cult problem. 

The  recognition  of  such  an  intangible  in  the  accounts  is  open 
to  some  objection,  however,  since  it  tends  to  cover  up  the  real 
rate  earned  by  the  enterprise.  The  capitalization  of  excess 
earning  power  due  to  public  favor  should  not  be  added  to  invest- 
ment and  made  the  basis  of  a  claim  for  higher  rates.  Franchise 
values  as  well  as  developmental  values  are  matters  of  significance 
only  in  connection  with  publicly  regulated  enterprises. 


PART   FIVE 

THE    CONSTRUCTION    AND    ANALYSIS    OF    FINAN- 
CIAL  STATEMENTS 


XXV 

THE  INCOME  SHEET 

BEFORE  the  accountant's  work  is  to  be  regarded  as  in  any 
proper  sense  completed,  the  information  contained  in  the  ledger 
accounts  must  be  summarized  in  some  statement  form  which 
will  make  the  meaning  of  the  accounts  reasonably  clear  to  all 
interested  parties.  Even  when  sound  accounting  principles 
have  been  followed  in  making  book  records  the  efforts  of  the 
accountant  are  often  vitiated  by  a  failure  to  present  the  informa- 
tion in  a  form  intelligible  to  those  who  have  no  adequate 
knowledge  of  accounting.  Too  often,  for  instance,  the  income 
sheet  and  balance  sheet  are  in  the  form  of  transcripts  of  ledger 
accounts  prepared  in  the  technical  account  form. 

Much  of  the  accountant's  skill  is  most  clearly  shown  in  the 
preparation  of  these  final  statements.  It  is  the  evident  function 
of  the  accountant  to  present  this  summarized  information  in 
adequate  form  for  the  guidance  of  the  manager.  It  is  almost  as 
evident  that  it  must  be  simple  and  straightforward  enough  for 
the  average  director  to  understand.  It  should  also  be  added 
that  the  accountant  has  another  type  of  interested  party  whose 
need  for  information  he  must  satisfy,  the  investor. 

There  is  little  wonder  that  as  he  has  little  or  no  understanding 
of  double-entry  bookkeeping  the  average  investor  gives  up  in 
despair  when  he  attempts  to  get  enlightenment  from  any  account- 
ant's statement  which  is  not  both  simple  and  unmistakably 
clear.  The  student  needs  but  to  recall  his  own  experiences  in 
attempting  to  master  the  intricacies  of  double-entry  book- 
keeping to  realize  the  difficulties  encountered  by  the  average 
individual  not  equipped  with  this  knowledge.  Therefore  as 
one  of  the  very  real  functions  of  the  accounting  statement 
may  be  to  furnish  enlightenment  to  the  prospective  or  present 
2N  545 


546  PRINCIPLES  OF  ACCOUNTING 

investor  the  accountant  must  hold  himself  responsible  for  state- 
ments adequate  to  this  need. 

It  will  therefore  be  the  purpose  of  Part  Five  to  discuss  the 
question  of  the  proper  presentation  of  accounting  data.  A 
knowledge  of  the  accounting  principles  developed  in  the  pre- 
ceding parts  will  be  assumed  in  this  discussion,  but  the  point  of 
view  taken  will  be  that  the  proper  presentation  of  accounting 
data  must  answer  the  needs  of  the  person  who  seeks  information 
from  the  accounts  but  who  has  not  a  training  in  accounting 
technique.  From  this  point  of  view  the  question  as  to  what 
information  is  of  importance  can  scarcely  be  regarded  apart 
from  the  other  vital  question  as  to  how  this  essential  information 
may  best  be  presented. 

As  has  been  shown  in  previous  connections,  the  principal 
types  of  accounting  data  are  concerned  with  the  historical 
situation  as  presented  primarily  in  the  income  sheet  and  with 
the  momentary  condition  on  definite  dates  as  presented  in  the 
balance  sheet.  There  is  a  very  close  connection  between  these 
two  statements  but  for  convenience  in  presentation  the  analysis 
will  be  made  in  separate  chapters  on  the  basis  of  this  classification. 
This  chapter  is  concerned  with  the  income  sheet. 

PURPOSES  OF  INCOME  SHEETS 

The  data  for  the  income  sheet  consist  essentially  of  the 
information  contained  in  the  Expense  and  Revenue  and  Net 
Revenue  accounts  in  the  ledger.  A  rather  large  number  of 
accounts  are  usually  kept  in  each  of  these  groups.  A  large 
corporation  may  have  several  hundred  expense  accounts  and 
probably  thirty  to  fifty  revenue  accounts  as  well  as  a  dozen  or 
more  net  revenue  accounts.  All  of  these  accounts  are  for 
income  sheet  purposes  but  a  simple  list  of  each  class  such  as  is 
contained  in  the  ten-column  statement  does  not  constitute  a 
well  organized  exhibit.  Such  a  list  of  accounts  would  be  quite 
unintelligible  to  an  investor  and  often  of  little  use  to  a  board  of 
directors  for  outlining  broad  business  policies.  Detailed  income 
accounts  are  of  service  for  some  purposes  but  are  cumbersome 
for  others.  Too  often  one  long  income  sheet  including  all  of 
the  accounts  representing  expense,  revenue,  and  net  revenue 


THE  INCOME   SHEET  .    547 

facts  is  prepared  to  cover  all  possible  uses.  This  is  decidedly  bad 
practice.  It  is  just  as  much  a  part  of  the  accountant's  function 
to  summarize  the  data  in  an  interesting  form  as  it  is  to  insure 
that  proper  accounting  principles  have  been  adhered  to.  The 
same  information  may  be  presented  in  a  variety  of  ways ;  and 
in  many  cases  a  series  of  income  sheets  covering  the  same  facts 
should  be  prepared  to  meet  the  needs  of  different  interested 
parties. 

Among  the  various  purposes  to  be  served  by  the  income  sheet, 
probably  the  use  of  this  statement  by  the  investor  is  the  most 
important.  In  order  to  judge  the  safety  of  the  investment 
offered,  the  investor  wishes  to  know  the  results  of  the  past  year's 
operations ;  and  it  is  generally  recognized  that  the  values  of 
corporation  securities  depend  largely  on  earning  capacity  in 
any  case.  This  fact  of  earning  power  should  be  shown  in 
the  income  sheet.  Stockholders  have  often  been  forced  to  ac- 
cept the  dividend  rate  as  a  basis  for  judging  the  earning  capac- 
ity where  income  sheets  either  were  not  available  or  were  not 
intelligible.  This  is  unfortunate,  for  dividends  do  not  tell  the 
whole  story.  If  part  of  the  income  is  retained  as  surplus  this 
increases  the  equity  of  the  stockholder,  and  the  probable  future 
earning  capacity,  and  hence  makes  the  stock  worth  more  than 
the  capitalized  dividends.  Cases  are  known  where  stocks  have 
been  quoted  on  the  market  at  as  low  as  fifty  per  cent  of  a  reason- 
able valuation  based  on  earning  capacity  as  would  have  been 
shown  by  an  accurate  income  sheet.  If  some  investors  have 
the  information  and  others  do  not  it  is  easy  to  see  how  unfair 
advantage  might  be  taken  of  this  situation. 

Closely  allied  to  the  needs  of  the  present  investor  are  those  of 
the  prospective  investor  or  creditor.  If  a  person  is  about  to 
invest  in  the  securities  of  a  concern,  he  should  be  supplied  with  a 
readable  report  of  the  past  earnings.  A  corporation  about  to 
float  a  new  issue  of  stocks  or  bonds  issues  a  prospectus  showing 
the  experience  of  the  past  and  an  estimate  of  future  income. 
The  income  sheet  for  such  a  purpose  should  be  drawn  up  in 
such  a  form  as  to  show  the  amount  of  income  which  would  have 
been  available  for  that  particular  class  of  security  in  the  past. 
On  the  basis  of  such  a  statement,  the  prospective  buyer  can 
reasonably  judge  the  amount  of  risk  involved.  The  price 


548  PRINCIPLES  OF  ACCOUNTING 

yielded  on  such  an  issue  can  be  materially  raised  on  the  basis  of 
adequate  information  over  what  it  would  be  without. 

Another  somewhat  different  type  of  investor  should  be  reached 
with  information  on  the  income  sheet.  This  is  the  speculator  in 
corporation  securities,  the  man  who  buys  and  sells  shares  for 
changes  in  the  market  price.  Whatever  may  be  said  as  to  the 
desirableness  of  this  type  of  investing,  the  fact  remains  that  it  is 
done  and  is  countenanced  by  law.  Further,  this  investor  per- 
forms an  economic  function  and  should  be  supplied  with  all  the 
information  possible  to  perform  his  function  efficiently.  It  was 
suggested  in  Chapter  I  that  one  of  the  chief  causes  for  the  business 
cycle  is  the  inability  of  the  business  world  generally  to  obtain 
reliable  information  with  regard  to  past  experience;  and  it 
may  be  added  here  that  an  adequate  series  of  income  sheets 
could  be  used  as  the  basis  for  a  barometer  of  business  conditions. 
What  the  speculator  needs  is  a  periodic  statement  of  the  income 
available  to  the  class  of  security  on  which  he  is  speculating,  and 
for  him  other  details  of  income  and  expense  are  unimportant. 

The  boarcf  of  directors  is  naturally  more  interested  in  the 
results  of  internal  operation  than  are  any  of  the  various  investors 
so  far  mentioned.  They  are  more  apt  to  ask  for  comparisons  of 
gross  revenues  with  preceding  years  and  likewise  the  amount 
of  expenses,  possibly  itemized  by  departments  or  functions. 
The  members  of  the  board  should,  of  course,  be  better  equipped 
with  technical  information  and  as  more  details  can  be  digested 
here  a  fuller  income  sheet  can  be  given  for  their  purposes.  Even 
here,  however,  groups  of  accounts  are  of  more  importance  than 
a  long  list  of  specialized  accounts.  The  board  of  directors  uses 
the  operating  accounts  to  judge  primarily  as  to  the  feasibility  of 
continuing  production,  increasing  the  rate  of  production,  and 
like  questions.  The  net  revenue  items  can  be  used  to  guide  in  a 
certain  measure  the  financial  policy,  but  whether  increased  invest- 
ments should  be  made  through  the  issue  of  stocks  or  of  bonds 
depends  on  the  present  proportion  of  fixed  charges  (interest)  to 
total  net  revenue. 

.  The  manager  on  the  other  hand  requires  a  much  more  exten- 
sive analysis  of  the  operating  accounts,  revenues  and  expenses. 
For  his  purposes  a  list  of  all  revenue  and  all  expense  accounts 
should  be  prepared  but  net  revenue  items  need  not  be  so  fully 


THE  INCOME  SHEET  549 

stated.  The  more  detailed  the  analysis  of  operating  accounts, 
the  better  it  serves  for  managerial  purposes.  It  is  for  this 
purpose  that  the  hundred  or  more  expense  accounts  are  kept. 

Very  often  special  occasions  arise  for  the  preparation  of  special 
reports  based  on  the  income  sheet  information.  The  govern- 
ment, for  example,  may  require  information  with  regard  to  costs 
of  operation  in  a  public  service  industry,  or  even  in  a  competitive 
industry  if  questions  of  discrimination  arise.  Again  in  cases 
of  purchase  of  complete  properties,  the  consolidation  of  com- 
peting concerns,  or  the  establishing  of  holding  companies  income 
sheets  arranged  in  special  form  are  essential.  In  fact  the  number 
and  kinds  of  cases  in  which  the  income  sheet  must  be  used  in 
some  form  are  practically  unlimited.  The  point  to  be  made 
is  that  the  ledger  accounts  must  be  analyzed  and  the  information 
arranged  in  such  a  form  that  it  will  furnish  direct  answers  to 
specific  questions.  In  the  following  sections  several  different 
forms  of  income  sheets  will  be  described. 


SUMMARY  INCOME   SHEETS 

As  was  stated  in  the  preceding  section,  a  very  brief  sum- 
marized statement  is  perfectly  adequate  for  the  use  of  the  average 
investor.  It  is  not  necessary  to  give  all  the  information  obtain- 
able in  a  statement  where  but  one  or  two  significant  figures 
would  be  amply  sufficient.  To  take  an  extreme  illustration  the 
following  would  be  income  sheet  enough  for  a  preferred  stock- 
holder who  desires  to  know  the  margin  of  safety  for  his  dividend 
payments : 

Net  revenue  before  preferred  stock 

dividends  are  paid $500,000 

Preferred  stock  dividends 300,000 

Balance $200,000 

The  first  item  in  this  statement  does  not  appear  as  such  in  any 
ledger  account.  It  is  found  rather  by  deducting  all  prior  dis- 
tributions of  net  revenue  from  the  total  net  revenue  figure. 
Further  it  may  be  noticed  that  a  free  use  of  words  is  made  to 
explain  just  what  the  $500,000  item  is.  In  an  income  sheet  every 
item  should  be  carefully  explained  as  the  use  of  just  a  ledger 


550  PRINCIPLES  OF  ACCOUNTING 

account  title  is  not  sufficient  for  statement  purposes.  The 
information  might  even  be  written  in  paragraph  form  in  order 
to  make  sure  that  the  reader  understands  just  what  is  meant. 

On  the  basis  of  such  a  brief  statement  as  the  one  given  above, 
together  with  a  series  of  like  statements  for  preceding  periods, 
the  preferred  stockholder  could  arrive  at  a  fair  judgment  as  to 
the  risk  involved  in  his  investment.  Likewise  the  prospective 
investor  and  speculator  can  use  such  a  statement  as  a  guide  in 
determining  what  action  to  take.  The  same  form  of  statement 
might  be  made  out  for  each  class  of  security  outstanding  for  the 
same  reason.  In  each  case  it  would  simply  involve  a  different 
combination  for  the  figures  in  the  Net  Revenue  account. 

A  somewhat  more  detailed  statement  is  usually  desired  by  the 
investor,  and  surely  by  the  board  of  directors,  even  when  the 
brief  statement  is  used.  Question  invariably  arises  as  to  the 
gross  business  done,  the  expenses,  taxes  and  fixed  charges  at 
least,  together  with  any  changes  in  the  free  surplus  or  undivided 
profits.  Those  questions  can  well  be  answered  in  a  very  brief 
summarized  income  and  surplus  sheet,  somewhat  as  follows  : 

Sales  (gross  revenue)  $5,500,000 

Expenses  4,600,000 

Net  revenue  from  operation  $    900,000 

Dividends  on  securities  owned  350,000 

Total  net  revenue  $1,250,000 

Taxes  50,000 

Net  revenue  to  all  private  equities  $1,200,000 

Fixed  charges  (interest  on  bonds)  700,000 

Net  revenue  to  stockholders  $    500,000 

Preferred  stock  dividends  $300,000 

Common  stock  dividends  150,000 

Total  dividend  appropriations  450,000 

Balance  carried  to  surplus  $      50,000 

Surplus  on  January  ist  580,000 

Appreciation  of  land  for  previous  years  15,000 

Total  surplus  $    645,000 

Exceptional  loss  charged  to  surplus  35,ooo 

Balance  of  surplus  on  December  3ist  $   610,000 


THE   INCOME   SHEET  551 

The  meaning  of  each  of  the  items  in  this  statement  is  quite 
evident.  The  first  item  states  that  the  sales  or  gross  revenue  for 
the  year  amounted  to  $5,500,000.  This,  of  course,  is  the  total 
of  all  gross  revenue  accounts  in  the  ledger,  or  may  be  more  con- 
veniently obtained  from  the  total  of  the  revenue  column  in  a 
ten-column  statement.  The  source  of  the  second  item  is  also 
obvious  as  this  is  the  total  of  the  expense  column  of  the  ten- 
column  statement.  The  difference  between  the  first  two  items 
is  the  net  revenue  from  operations  —  the  difference  between  the 
expense  and  revenue  columns  mentioned  in  the  ten-column 
statement.  The  items  down  to  this  point  constitute  what  is 
called  the  operating  division  of  the  income  sheet.  These  facts 
concern  the  operations  of  the  business  as  distinct  from  the 
distribution  of  net  revenue.  All  gross  revenue  and  expense 
items  listed  in  an  income  sheet,  no  matter  how  detailed,  make  up 
the  operating  division. 

The  proportion  of  expenses  to  gross  revenue  is  looked  upon  by 
the  investor  as  an  important  figure.  It  is  on  the  basis  of  this 
figure  that  comparisons  can  be  made  as  to  the  risk  involved 
as  between  various  lines  of  business.  The  percentage  figure  thus 
obtained  (expenses  divided  by  revenues)  expresses  the  amount  of 
each  dollar  of  sales  consumed  in  operating  expenses  and  thus  a 
sort  of  norm  is  established  for  different  types  of  business.  In 
the  manufacturing  business  a  rather  high  percentage  is  common, 
eighty  per  cent  and  up  almost  to  one  hundred  per  cent,  showing 
that  the  margin  left  for  meeting  the  contractual  obligations  is 
small.  A  fall  in  the  demand  for  product  is  likely  to  affect  the 
investor's  interests  relatively  soon.  This  does  not  mean  that 
profits  may  not  be  high  in  proportion  to  investment.  In  fact 
rates  of  net  revenue  to  invested  capital  usually  do  run  quite 
high  because  of  the  frequent  turnover  of  the  stock.  The  fact 
remains  that  when  the  operating  ratio  is  very  high,  the  risk 
is  also  relatively  high.  On  the  other  hand  railroad  and  public 
utilities  have  a  much  lower  operating  ratio,  usually  from  about 
fifty-five  to  seventy-five  per  cent.  The  amount  of  risk  is  not  as 
great  as  changes  in  gross  revenue  would  not  affect  the  investor's 
claims  as  rapidly  as  if  the  ratio  were  larger.  Net  revenues  in 
such  cases  are  usually  smaller  in  proportion  to  total  investment 
because  of  the  few  turnovers  possible.  In  the  illustration  given 


552  PRINCIPLES  OF  ACCOUNTING 

the  operating  ratio  is  approximately  eighty-five  per  cent.  This 
is  quite  favorable  for  a  manufacturing  business. 

The  next  group  of  items,  from  "net  revenue  from  operation" 
down  to  "balance  carried  to  surplus"  constitutes  the  net  revenue 
division  of  the  income  sheet.  This  is  an  analysis  of  the  Net 
Revenue  account  or  of  the  net  revenue  columns  in  the  ten- 
column  statement.  First  are  listed  the  credits  to  net  revenue. 
In  this  case,  dividends  on  securities  owned  constitute  the  sole 
item  of  this  class.  Other  possible  items  would  be  interest  on 
bonds  owned,  appreciation  of  certain  assets  and  other  accruals 
of  net  revenue  for  the  period. 

Taxes  are  the  first  deduction  from  the  total  net  revenue.  The 
balance  remaining  constitutes  net  revenue  available  to  the 
private  equities.  It  has  been  shown  earlier  in  the  text  that  the 
proper  place  for  the  tax  item  is  a  matter  of  some  uncertainty. 
Should  it  be  considered  an  expense  or  as  a  distribution  of  net 
revenue?  It  does  not  come  within  the  general  class  of  expense 
items,  namely,  expirations  of  commodities  and  services  purchased, 
nor  is  it  a  distribution  to  private  equities.  Inasmuch  as  it 
partakes  more  of  the  characteristics  of  the  net  revenue  items 
than  of  expense,  it  has  been  placed  in  the  net  revenue  group  of 
accounts  in  the  classifications  so  far  presented.  It  is  sufficiently 
different  from  other  debits  to  Net  Revenue,  however,  to  be 
accorded  a  special  place  in  the  income  sheet  and  this  is  what  was 
done  here,  but  the  essential  fact  is  that  the  amount  of  net 
revenue  left  for  the  private  investors  can  be  obtained  only  by 
making  the  tax  deduction  as  a  separate  item.  First,  then,  the 
total  net  revenue  is  obtained  in  the  manner  already  shown  and 
second  the  amount  of  this  net  revenue  which  belongs  to  the 
private  investors  as  a  whole  is  found  by  deducting  the  tax 
accruals.  The  tax  items  are  the  one  class  of  expenditures  which 
are  controlled  entirely  from  authority  outside  of  the  business 
organization.  All  expenses  are  incurred  as  the  result  of 
managerial  judgments,  all  distributions  of  net  revenue  to 
private  equities  are  the  result  of  financial  programs  entered 
into  by  the  board  of  directors.  The  authority  for  taxes 
comes  from  governmental  legislative  bodies.  In  the  case  of 
a  publicly  owned  property,  all  net  revenue  after  payments 
of  contractual  interest  can  be  considered  as  in  the  nature  of  a 


THE  INCOME  SHEET  553 

tax.  In  this  case  proprietary  net  revenue  is  virtually  a  tax  on 
the  consumer. 

There  are  two  general  types  of  distributions  to  private  equities, 
contractual  deductions,  usually  called  fixed  charges,  and  appro- 
priations of  the  proprietary  net  revenue.  It  is  convenient  to 
make  the  next  deductions  on  this  basis.  First  the  fixed  charges 
consisting  of  interest  on  bonds,  amounting  in  the  illustration 
to  $700,000,  are  deducted  from  net  revenue  accruing  to  the  private 
equities,  leaving  the  proprietary  net  revenue,  or  as  it  is  called 
in  this  statement,  "  net  revenue  to  stockholders  " ;  and  it  is  from 
this  figure  that  the  board  of  directors  makes  its  appropriations. 
In  the  case  given  the  preferred  and  common  stock  dividends 
constituted  all  of  the  appropriations  made.  Other  possible 
appropriations,  examples  of  which  were  given  in  Chapter  XIII, 
would  also  be  listed  here.  The  financial  policy  of  the  corporation 
is  evidenced  by  the  proportion  of  fixed  charges  to  total  net 
revenue  available  to  the  private  equities.  In  case  the  fixed 
charges  are  small  in  proportion  to  the  private  net  revenue,  the 
risk  taken  by  the  bondholder  is  light  and  bonds  should  float 
at  a  low  rate  of  interest.  On  the  other  hand  if  fixed  charges 
are  high,  risks  are  high,  because  of  the  lack  of  a  large  proprietary 
net  revenue  as  a  buffer,  and  the  bonds  would  float  at  a  higher 
rate  of  interest.  These  comparisons  are  of  importance  to  all 
classes  of  investors. 

There  are  then  at  least  four  quite  distinct  net  revenue  figures 
in  the  income  sheet,  (i)  net  revenue  from  operation;  (2)  total 
net  revenue ;  (3)  net  revenue  to  private  equities ;  and  (4)  pro- 
prietary net  revenue.  The  importance  of  the  different  items 
varies  in  different  types  of  business,  and  in  some  cases  the  number 
might  be  greater  than  four,  but  each  of  those  cited  is  distinc- 
tive and  should  be  shown  in  some  form  in  every  completed 
income  sheet.  Finally  the  balance  of  net  revenue  not  appro- 
priated is  carried  to  the  surplus  sheet,  and  this  completes  the 
income  sheet  figures. 

The  surplus  sheet  is  practically  a  transcript  of  the  Surplus 
account  in  the  ledger.  As  stated  in  Chapter  XIII  this  usually 
represents  the  excess  of  proprietorship  over  the  par  value  of 
stock  outstanding,  although  there  may  be  in  some  cases  several 
accounts  of  this  nature.  In  any  event  the  Surplus  account 


554  PRINCIPLES  OF  ACCOUNTING 

represents  the  accumulated  unappropriated  net  revenue  from 
date  of  organization  and  as  such  is  a  connecting  link  between  the 
income  sheet  and  the  balance  sheet.  The  balance  from  the 
income  sheet  is  carried  to  Surplus  and  the  balance  of  the  Surplus 
account  is  listed  in  the  balance  sheet.  Hence  in  the  statement 
of  an  income  sheet  it  is  customary  to  append  a  surplus  sheet 
as  the  connecting  item.  In  the  first  place,  the  previous  balance 
in  surplus  as  shown  on  the  balance  sheet  at  the  beginning  of  the 
period  is  placed  just  below  the  income  sheet  item  "  balance 
carried  to  surplus."  In  the  illustration  given  above,  this  item 
is  $580,000.  Following  this  are  listed  all  additions  to  surplus 
during  the  period,  exclusive  of  that  shown  in  the  income  sheet. 
The  various  occasions  for  credits  to  Surplus  were  explained  in 
Chapter  XIII.  One  type  was  shown  in  the  illustration,  an 
appreciation  in  the  value  of  land  which  had  accrued  in  previous 
years  but  was  being  recognized  for  the  first  time.  The  surplus 
statement  takes  care  of  all  net  increases  in  proprietorship  for 
some  previous  periods.  It  must  be  emphasized  again  that  the 
income  sheet  contains  figures  pertaining  exclusively  to  a  single 
accounting  period  and  that  all  changes  for  other  periods  must 
be  made  in  the  surplus  sheet. 

The  sum  of  the  three  items  mentioned  (balance  from  income 
sheet,  balance  of  surplus  at  beginning  of  period,  and  credits  to 
surplus  during  the  period)  makes  up  the  total  surplus.  This, 
of  course,  is  equal  to  the  total  credit  side  of  the  Surplus  account. 
Next  all  appropriations  from  surplus  are  made.  In  the  illus- 
tration given  an  exceptional  loss  such  as  results  from  a  flood  or 
fire  was  shown.  Another  typical  case  would  be  an  appropriation 
of  dividends  either  cash  or  stock.  The  surplus  is  a  part  of  pro- 
prietorship and,  of  course,  can  be  disposed  of  as  the  directors 
decide.  All  decreases  in  proprietorship  for  past  periods  which  are 
now  recognized  for  the  first  time  should  be  deducted  here. 
Finally  the  net  figure  is  the  amount  carried  as  surplus  on  the 
balance  sheet  at  the  end  of  the  period. 

To  summarize  this  discussion,  the  income  and  surplus  sheets 
taken  together  give  a  complete  history  of  operating  and  financial 
operations  in  so  far  as  they  have  resulted  in  net  changes  in  the 
equities  for  the  accounting  period.  The  income  sheet  deals 
exclusively  with  the  accounting  period  and  the  surplus  sheet  is  a 


THE  INCOME   SHEET  555 

summary  of  the  accumulation  of  surplus  to  date.  'The  income 
sheet  in  turn  has  two  distinct  divisions:  (i)  operating,  corre- 
sponding to theexpense andrevenue  accounts,  and  (2)  netrevenue, 
corresponding  to  the  net  revenue  accounts.  The  extent  to  which 
the  two  divisions  may  be  itemized  is  entirely  a  matter  of 
expediency.  In  the  illustration  given  the  material  was  sum- 
marized in  very  brief  form  but  the  amount  of  information  which 
may  be  given  under  any  heading  is  limited  only  by  the  degree 
of  specialization  maintained  in  the  ledger  accounts. 


THE   COMPARATIVE   INCOME    SHEET 

While  an  income  sheet  covering  one  year's  operations  gives 
valuable  data  for  financial  purposes,  it  will  readily  be  recognized 
that  the  facts  are  of  much  more  significance  when  comparisons 
can  be  made  with  other  companies  conducting  the  same  line  of 
business  or  with  the  previous  experience  of  the  same  concern. 
Comparisons  with  another  concern  can  be  made  only  when  it  is 
assured  that  both  have  adhered  to  the  same  accounting  principles 
and  have  used  essentially  the  same  classification  of  accounts. 
The  great  diversity  of  accounting  practice  at  the  present  time 
prevents  any  wide  use  of  -  such  comparisons,  though  there  is 
an  evident  tendency  toward  greater  uniformity.  The  Interstate 
Commerce  Commission  has  standardized  the  classification  of 
accounts  for  the  railroads  and  other  public  utilities  under  its 
jurisdiction.  State  public  utility  commissions  are  doing  the 
same  for  the  utilities  which  they  control,  so  that  in  the  public 
utility  field  comparisons  can  very  well  be  made  between  the 
income  sheets  of  different  companies.  There  have  been  move- 
ments by  some  of  the  manufacturing  associations  and  retail 
organizations  to  effect  the  same  results  for  industrials.  The 
acceptance  of  uniform  systems  by  individual  concerns  in  this 
case  is  purely  voluntary,  however,  and  hence  it  will  doubtless 
be  some  time  before  any  very  tangible  results  will  be  attained 
in  the  industrial  field. 

Direct  comparisons  can  be  made,  however,  between  income 
sheets  covering  different  periods  for  the  same  concern,  and  these 
comparisons  are  of  importance  to  all  interested  parties.  Of 


556  PRINCIPLES  OF  ACCOUNTING 

course,  if  the  investor  saves  the  successive  income  sheets  as  they 
are  published  he  can  make  the  comparisons  himself.  But  in  the 
first  place  reports  are  not  saved  as  a  general  rule  even  by  those 
investors  who  retain  possession  of  their  securities  for  long  periods 
of  time.  Further  the  constant  shifting  of  the  ownership  of 
securities  makes  such  information  unavailable  to  new  investors 
unless  a  comparative  statement  is  issued  each  time  an  income 
sheet  is  prepared.  Comparative  figures  for  each  item  in  the 
income  sheet  should  be  given  for  several  years  so  that  the  in- 
vestors can  judge  as  to  the  normal  operating  condition  of  the 
concern.  Some  corporations  make  a  practice  of  presenting  a 
series  of  from  two  to  ten  annual  income  sheets  in  parallel  columns, 
and  this  is  a  commendable  practice.  Even  two  successive  in- 
come sheets  are  of  convenience  if  the  changes  in  the  items 
are  brought  out  clearly,  perhaps  in  a  third  column  showing  in- 
creases and  decreases.  It  might  be  well  in  some  cases  to  add  a 
considerable  discussion  in  narrative  form  explaining  the  changes 
in  so  far  as  it  is  possible  to  do  so.  Some  accountants  object  to 
placing  an  opinion  as  to  the  prospects  of  a  concern  on  record, 
on  the  assumption  that,  given  the  same  set  of  figures,  the  investor 
should  be  able  to  arrive  at  conclusions  of  his  own.  It  would 
seem  that  a  much  more  reasonable  stand  would  be  that  the 
accountant  should  not  only  prepare  the  tabulated  statements  but 
should  give  whatever  additional  technical  information  he  might 
be  able  to  obtain.  At  least  if  this  is  not  done  by  the  accountant, 
some  responsible  officer  of  the  concern  should  prepare  some 
narrative  statement  based  upon  the  income  sheet. 

The  following  is  a  very  brief  comparative  income  sheet  to- 
gether with  an  additional  descriptive  statement  such  as  might 
be  given  to  explain  the  changes  in  the  figures  given.  The  income 
sheets  are  for  the  X  Company,  a  manufacturing  enterprise, 
and  cover  the  operations  of  the  years  1917  and  1916.  Increases 
and  decreases  are  shown  in  the  third  column.  Decreases  are 
designated  by  the  prefix  d  and  no  designation  is  given  the  figures 
representing  increases. 


THE  INCOME   SHEET 


557 


1917 

1916 

INCREASES  OR 
DECREASES 

Gross  revenue 
Expense 

$4,500,000 
3,800,000 

$4,350,000 
3,500,000 

$150,000 
300,000 

Net  revenue  from  operation 
Taxes 

$    700,000 
1  50,000 

$    850,000 
95,000 

(d)     1  50,000 
55,000 

Net  revenue 
Interest 

$    550,000 
315,000 

$    75S,ooo 
300,000 

(d)     205,000 
15,000 

Net  revenue  for  stockholders 
Dividends 

$    235,000 
215,000 

$    455,ooo 
215,000 

(d)     220,000 

Carried  to  surplus 
Surplus  Jan.  ist 

$      20,000 
1,345,000 

$    240,000 
1,230,000 

(d)   229,000 
115,000 

Loss  on  abandoned  property 

$1,365,000 
35,000 

$1,470,000 
125,000 

(d)      90,000 

Surplus  Dec.  3ist 

$1,330,000 

$1,345,000 

(d)      15,000 

Sales  for  the  year  1917  were  $4,500,000,  an  increase  of  $150,000  over  the 
sales  for  1916.  This  is  due  almost  entirely  to  the  fact  that  higher  prices 
were  charged  for  the  products  sold  and  not  to  an  increased  volume  of  busi- 
ness. The  amount  of  product  manufactured  was  very  little  in  excess  of 
that  for  last  year.  Expenses  were  $3,800,000,  an  increase  of  $300,000  over 
the  same  item  in  1916.  Large  increases  in  wages  as  well  as  increased  prices 
of  raw  materials  explain  this  increase.  The  efficiency  of  the  operatives 
has  if  anything  increased  during  the  year  but  not  sufficiently  to  offset  the 
increased  wages  and  other  prices. 

Net  revenue,  it  will  be  noted,  was  only  $700,000  as  compared  with 
$850,000  in  the  previous  year.  Inability  to  raise  prices  of  finished  product 
as  rapidly  as  prices  of  raw  materials  and  wages  advanced  is  the  cause  of  this 
situation.  The  management  confidently  believes  that  prices  of  finished 
product  will  rise  sufficiently  during  the  next  few  weeks  to  offset  the  tendency 
shown  in  this  figure. 

Taxes  were  $150,000,  an  increase  of  $55,000  over  the  1916  taxes.  This, 
of  course,  is  explained  largely  by  the  increased  federal  income  and  excess 
profits  taxes  for  the  year.  There  were  also  some  increases  in  local  taxes. 
The  amount  of  net  revenue  left  after  deducting  taxes  was  $550,000,  a  decrease 
of  $205,000  from  last  year.  Of  course  the  tax  policy  of  the  government 
will  enter  largely  into  the  question  as  to  whether  this  figure  can  be  ma- 
terially increased  another  year. 

The  fixed  charges,  consisting  of  interest  on  bonds,  increased  $15,000  to 
$315,000.  This  increase  was  caused  by  the  issue  of  $300,000  second  mort- 
gage bonds,  the  funds  being  required  for  improvements  and  extensions. 
The  regular  dividend  rate  was  maintained  and  a  balance  of  $20,000  was 
carried  to  surplus.  This,  it  is  true,  is  quite  a  narrow  margin  but,  as  was 


558  PRINCIPLES  OF  ACCOUNTING 

slat  I'd  above,  improved  operating  conditions  are  expected  in  the  near  future 
through  increased  prices,  and  there  is  every  likelihood  that  the  regular 
dividends  will  be  earned.  Further,  even  if  the  earnings  should  turn  out  to 
be  low,  the  surplus  balance  is  sufficient  to  maintain  the  regular  dividend 
payments  for  some  time.  The  necessity  for  tapping  surplus,  however,  is 
unlikely. 

Such  a  statement  as  this  expresses  the  opinion  of  the  accountant 
or  other  official  with  regard  to  the  facts  represented  in  the  com- 
parative income  sheet.  An  expert  opinion  of  probable  future 
conditions  is  of  considerable  help  to  the  investor,  especially 
if  he  is  not  equipped  to  make  such  judgments  himself. 


SOME   SPECIAL  FORMS   OF   INCOME   SHEETS 

In  the  preceding  sections,  the  general  divisions  of  the  typical 
income  sheet  were  described  and  the  importance  of  comparative 
statements  emphasized.  This  covers  the  general  considerations 
with  regard  to  income  sheets.  In  specific  cases  it  is  desirable  to 
emphasize  certain  special  facts  necessitating  the  combination  of 
accounts  in  different  ways.  The  actual  form  of  an  income  sheet 
naturally  depends  on  just  what  information  it  is  desirable  to 
show.  It  would  obviously  be  impossible  to  give  here  an  ade- 
quate description  of  very  many  forms,  least  of  all  to  cover  all 
possible  cases,  but  a  few  illustrative  income  sheets  will  serve  to 
show  the  extent  to  which  the  accounting  information  may  be 
arranged  in  report  form. 

In  a  manufacturing  business  it  is  quite  desirable  to  report  the 
expenses  incurred  by  the  various  departments  so  that  the  board 
of  directors  or  at  least  the  chief  administrative  officer  can  locate 
more  accurately  the  particular  department  within  which  expenses 
have  increased.  On  the  basis  of  such  knowledge,  policies  can 
be  revised  and  improvements  in  operating  methods  suggested. 
A  very  brief  statement  for  a  manufacturing  company  might 
be  as  shown  at  top  of  next  page. 

The  expenses  are  classified  into  manufacturing,  selling,  and 
administration  groups,  the  first  two  corresponding  to  the  depart- 
ments controlled  by  the  factory  manager  and  the  sales  manager 
and  the  third  representing  the  general  office  expenses  which  are 


THE  INCOME  SHEET  559 

Sales  of  product  $5,057,569 

Manufacturing  expenses  $4,092,686 

Selling  expenses  509,385 

Administration  expenses  110,250 

Total  expenses  k        4,712,321 

Net  operating  revenue  $   345,248 

Taxes  21,350 

Net  revenue  $   323,898 

Interest  on  ist  m'tg.  bonds  $    125,200 

Interest  on  2nd  m'tg.  bonds  35,185 

Interest  on  equipment  notes  18,395 

Total  fixed  charges  178,780 

Net  revenue  to  stockholders  $    145,118 

Sinking  fund  contribution  $      25,200 

Dividends  85,300 

Total  appropriations  1 1  o ,  500 

Balance  carried  to  surplus  $     34,618 

not  conveniently  chargeable  to  either  department.  It  may  be 
said  that  to  a  certain  extent  the  factory  manager  is  responsible  for 
the  expenses  incurred  in  the  process  of  manufacturing.  He 
makes  certain  judgments  as  to  the  methods  to  be  adopted  in 
production  and  as  a  result  incurs  the  manufacturing  expense. 
He  should  be  called  upon  to  explain  changes  in  the  total  manu- 
facturing expenses  between  various  periods.  Particularly  should 
changes  in  the  ratio  of  these  expenses  to  the  gross  sales  be 
explained.  This  does  not  mean  that  this  ratio  in  any  sense 
measures  the  efficiency  of  the  factory  manager.  He  cannot  con- 
trol the  price  of  labor  nor  of  the  materials  which  must  necessarily 
be  purchased,  and  hence  an  increase  in  the  cost  of  these  items 
does  not  reflect  upon  the  ability  of  the  manager  to  produce  on  an 
efficient  basis.  In  other  words,  the  manager  should  be  able  to 
explain  the  changes  in  manufacturing  expenses  but  should  not 
be  held  entirely  responsible  for  the  same. 

Questions  regarding  the  changes  in  selling  expenses  from  period 
to  period  should  be  referred  to  the  sales  manager  in  a  like  manner. 
This  item  includes  all  expenses  incurred  by  the  selling  organiza- 
tion, such  as  salesmen's  salaries,  advertising,  and  depreciation  of 
selling  equipment.  The  ratio  of  these  expenses  to  the  gross 
sales  is  usually  followed  quite  closely  from  period  to  period  and  in 
many  lines  of  business  reaches  a  fairly  normal  standard.  In 


560  PRINCIPLES  OF  ACCOUNTING 

certain  lines  of  manufacturing  it  is  as  low  as  five  per  cent  while 
in  others  it  amounts  to  more  than  the  manufacturing  expense. 
In  the  retail  business  practically  all  of  the  expenses  incurred 
(aside  from  the  purchase  price  of  .the  goods  sold)  come  under 
this  head  and  amount  to  from  fifteen  per  cent  to  as  high  as 
thirty-five  per  cent  of  the  gross  sales.  In  place  of  manufacturing 
expenses  in  such  a  statement,  the  purchase  price  of  merchandise 
sold  is  listed  in  the  income  sheet. 

The  administrative  expense  items  include  all  of  that  group  of 
expenses  which  cannot  be  apportioned  to  either  the  manu- 
facturing or  the  selling  departments,  such  as  the  general  officers' 
salaries,  legal  and  accounting  expenses,  and  the  like.  Sometimes 
an  arbitrary  method  of  apportioning  these  expenses  to  the  manu- 
facturing and  selling  departments  is  employed  and  in  this  case 
no  administrative  expense  item  appears  in  the  income  sheet. 
The  salary  of  the  president,  for  example,  is  charged  partly  to 
manufacturing  expense,  and  partly  to  selling  expense.  The 
apportionment  is  supposed  to  represent  the  relative  cost  of  his 
services  to  the  two  departments.  It  can  be  seen  that  such  an 
apportionment  must  at  best  be  very  arbitrary.  Further  it  is 
doubtful  if  this  adds  to  the  usefulness  of  the  expense  ac- 
counts. In  fact,  combining  such  unlike  items  in  the  same 
expense  account  seems  to  confuse  rather  than  aid  in  the  inter- 
pretation of  the  statements.  The  administrative  officers  per- 
form as  separate  and  distinct  a  function  as  do  the  factory  superin- 
tendent and  sales  manager,  and  it  would  be  well  to  keep  adminis- 
trative expenses  in  separate  accounts.  In  a  functional  classifica- 
tion at  least  administrative  and  general  expenses  should  be 
clearly  separated  from  the  other  departmental  expenses. 

Taxes  surely  cannot  be  charged  against  the  expense  accounts 
of  a  department  nor  to  the  general  expense  since,  as  has  been 
shown  before,  these  constitute  a  deduction  from  net  revenue. 
It  might  be  well,  however,  to  keep  a  separate  account  for  the 
different  kinds  of  taxes  paid,  that  is,  one  for  federal,  one  for 
state,  one  for  local,  etc.  This  would  be  of  some  importance  to 
the  management  in  making  comparisons  with  the  normal  taxes 
in  other  localities.  The  remaining  items  in  the  above  illustration 
are  contractual  distributions  and  proprietary  appropriations  and 
these  were  discussed  fully  in  the  preceding  section. 


THE  INCOME  SHEET  561 

In  the  illustration  just  given  gross  revenue  was  stated  in  one 
item  —  sales.  This  would  cover  the  situation  for  a  plant  manu- 
facturing one  homogeneous  product,  or  even  one  which  makes 
one  main  product  together  with  several  by-products.  If  more 
than  one  class  of  product  is  manufactured,  however,  it  would  be 
advisable  to  keep  a  separate  sales  account  for  each  class  and  to 
list  each  separately  on  the  income  sheet.  Thus  a  plant  manu- 
facturing rubber  goods  might  have  a  list  of  gross  revenue  items 
like  this : 

Sales  of  auto  tires  $795,200 

Sales  of  rubber  boots  195,300 

Sales  of  plumber's  rubber  goods  100,500 

Sales  of  rubber  mats  7  5, 400 

Sales  of  miscellaneous  rubber  goods  25,800 

Total  gross  sales  $1,192,200 

This  gives  an  impression  of  the  volume  of  business  done  in  the 
different  lines.  This  does  not,  however,  give  an  idea  as  to  the 
profitableness  of  the  different  lines.  The  expenses  are  still 
listed  on  a  functional  basis.  The  manufacturing,  selling,  and 
administrative  expenses  are  listed  in  totals  and  have  not  been 
apportioned  to  the  separate  kinds  of  goods  manufactured.  If 
all  of  the  goods  are  manufactured  with  essentially  the  same 
equipment,  buildings,  machines,  supplies,  labor,  etc.,  it  would 
be  quite  impossible  to  separate  the  expenses  to  show  the  cost  of 
manufacturing  and  selling  the  different  products.  It  is  true  that 
systems  of  cost  accounts  are  used  to  apportion  on  a  more  or  less 
arbitrary  basis  the  expenses  to  the  different  products  produced, 
and  that  statistics  thus  obtained  from  the  cost  accounts  are  of 
considerable  importance  to  the  manager ;  but  such  details  would 
have  little  significance  if  carried  to  the  income  sheet.  These 
facts  would  be  used  primarily  by  the  manager  to  determine 
roughly  the  relative  costs  of  producing  the  different  products 
as  compared  with  the  prices  obtained  from  the  sale  of  the  same ; 
and  such  information  will  determine  to  a  certain  extent  the  lines 
of  goods  to  be  produced.  In  reporting  expenses  in  the  income 
sheet,  however,  the  functional  classification  should  be  followed. 
Arbitraries  should  be  excluded  from  financial  statements  as  far 
as  possible.  The  important  thing  to  show  for  income  sheet 
purposes  is  the  total  of  each  class  of  expenses. 

20 


562  PRINCIPLES  OF  ACCOUNTING 

There  are  certain  cases,  however,  in  which  it  is  advisable  to 
show  expenses  according  to  products  or  service  performed.  A 
corporation,  for  example,  may  operate  entirely  distinct  plants 
each  producing  a  separate  product.  In  such  a  case  the  functional 
classification  can  be  used  for  each  of  the  plants  the  same  as 
though  the  operations  were  carried  on  by  separate  corporations. 
The  public  utility  industry  affords  a  typical  illustration  of  this 
form  of  organization.  Frequently  several  forms  of  public  service, 
such  as  the  supplying  of  gas  and  electricity,  are  produced  by  the 
same  corporation.  A  separate  organization  is  maintained  for 
each  of  the  plants  and  it  is  both  convenient  and  advisable  to  keep 
separate  classifications  of  operating  accounts  for  each  of  the 
different  properties.  In  this  case  there  would  be  little  occasion 
for  the  use  of  an  arbitrary  apportionment  of  expenses.  The 
administrative  expenses  would  have  to  be  divided,  but  any  other 
expense  would  for  the  most  part  pertain  exclusively  to  one  of 
the  plants.  The  following  is  an  illustration  of  an  income  sheet 
for  a  corporation  operating  both  an  electric  and  a  gas  business. 

Gross  revenue  —  gas  $246,300 

Operating  expense  —  gas  147,600 

Net  revenue  —  gas  $  98,700 

Gross  revenue  —  electric  $385,600 

Operating  expense  —  electric  225,300 

Net  revenue  —  electric  160,300 

Net  revenue  —  gas  and  electric  $259,000 

Taxes  15,185 

Net  revenue  to  private  equities  $243,815 

Interest  on  bonds  138,325 

Net  revenue  available  to  stockholders  $105,490 
Sinking  fund  installment                           $  12,200 

Dividends  declared  75,000 

Total  appropriations  87,200 

Balance  carried  to  surplus  $  18,290 

The  separating  of  the  different  businesses  as  was  done  above 
is  of  interest  to  the  investor.  The  amount  invested  in  each  of  the 
properties  may  be  shown  on  the  balance  sheet.  The  net  revenue 
for  each  type  of  service  as  shown  by  the  income  sheet  divided  by 
the  investment  shows  the  rate  of  return  from  each  of  the  different 


THE  INCOME  SHEET  563 

properties,  and  incidentally  can  be  used  to  gauge  the  risk  involved. 
Likewise  the  public  official  having  the  task  of  regulating  rates  is 
interested  in  having  the  income  sheet  prepared  in  this  form.  It 
is  often  considered  poor  public  policy  to  allow  the  revenue  from 
one  service  to  cover  the  expenses  of  another.  If  the  gas  business 
shows  a  net  loss  instead  of  a  net  revenue,  for  example,  while  the 
electric  plant  made  a  large  enough  net  revenue  to  yield  a  reason- 
able return  on  the  entire  investment,  the  customers  of  the  electric 
department  might  be  said  to  be  paying  partly  for  the  bills  of  the 
customers  of  the  gas  department.  This  may  or  may  not  be  a 
good  policy,  but  whether  it  is  or  not,  the  income  sheet  drawn 
up  in  the  above  form  shows  the  true  situation.  With  such  a 
statement  as  a  basis,  judgments  can  be  made  as  to  general  rate 
policies. 

This  form  of  income  sheet  would  be  of  service  wherever  different 
businesses  are  carried  on  under  one  organization.  Sometimes  a 
corporation  which  is  primarily  engaged  in  a  manufacturing 
business,  for  example,  operates  a  real  estate  business  in  addition. 
An  income  sheet  such  as  the  one  just  described  would  show  the 
operating  results  of  the  two  businesses  separately. 

FURTHER   CLASSIFICATION   OF    OPERATING   ACCOUNTS 

The  income  sheets  shown  in  the  preceding  illustration  have 
all  been  for  general  purposes  —  for  the  investor,  the  board  of 
directors,  and  the  general  administrative  officer  alike.  For  such 
general  purposes  details  are  undesirable  and  hence  the  income 
sheets  presented  were  summarized  in  rather  compact  form.  It 
is  better  to  give  a  little  information  in  understandable  form  than 
to  give  a  great  deal  in  complex  form.  The  investor  is  primarily 
interested  in  net  revenue  and  its  distribution,  hence  the  net 
revenue  division  is  of  most  importance  and  is  itemized  more 
fully.  On  the  other  hand  the  manager  desires  a  rather  detailed 
list  of  operating  accounts.  What  were  the  gross  sales  of  each 
of  the  different  kinds  of  products  sold,  and  what  was  the  expense 
incurred  for  each  separate  function  performed?  These  are  the 
questions  asked  by  the  manager,  and  classifications  of  operating 
accounts  are  of  use  in  answering  these  questions. 

It  is  a  relatively  simple  matter  to  keep  a  rather  extensive 


564  PRINCIPLES  OF  ACCOUNTING 

classification  of  revenue  accounts.  The  entries  to  the  credit  of 
gross  revenue  accounts  are  made  only  as  a  result  of  formal 
sale  transactions  and  a  separate  sales  account  may  be  kept  for 
every  kind  of  commodity  sold.  These  might  be  very  few  in 
number  or  may  run  into  the  hundreds ;  but  no  technical  dif- 
ficulties arise. 

The  expense  classification  is  more  complicated,  however. 
The  difficulty  here  arises  from  the  fact  that  a  complex  equipment 
together  with  various  forms  of  services  enter  into  the  producing 
of  a  single  product.  Fixed  assets,  current  assets,  and  labor 
services  are  all  used  together  to  produce  the  product  of  a  period. 
The  expense  incurred  through  the  use  of  fixed  assets  consists  of 
depreciation  and  of  repair  costs  as  was  explained  in  Chapter 
XXII.  The  repair  costs  may  be  incurred  through  the  purchase 
of  new  parts  and  the  use  of  certain  labor  services  to  make  the 
adjustments,  or  through  the  use  of  supplies  on  hand,  together 
with  labor  services,  or  the  whole  job  might  be  contracted  for 
with  outside  parties.  The  expense  character  of  the  repair  job 
is  evident  regardless  of  how  accomplished,  but  if  the  manager 
desires  a  statement  of  repair  costs  as  distinct  from  other  ex- 
penses, this  may  be  a  difficult  matter. 

This  complexity  in  the  use  of  supplies  and  services  is  present 
in  practically  every  type  of  expense  which  might  be  mentioned. 
What  then  should  be  the  basis  for  the  classification  of  expense 
items  ?  Raw  materials  in  the  case  of  a  manufacturing  industry 
can  usually  be  set  down  without  difficulty  as  one  significant 
account.  The  cost  of  materials  purchased  and  placed  in  the 
manufacturing  process  also  constitutes  one  distinct  type  of 
manufacturing  expense  which  is  easily  segregated  and  may  be 
used  for  managerial  purposes.  The  next  item  which  logically 
presents  itself  is  the  cost  of  labor  and  the  total  wages  paid  may 
be  ascertained  from  the  payroll  vouchers ;  but  it  does  not  follow 
that  the  labor  expense  should  be  taken  as  one  expense  account. 
In  most  cases  very  little  use  could  be  made  of  a  statement 
showing  simply  total  labor  expense,  as  what  is  desired  is  an 
exhibit  which  shows  the  different  purposes  for  which  labor  is 
used.  As  was  shown  in  the  preceding  paragraph,  part  is  used 
for  repair  work  to  fixed  assets  and  part  is  used  directly  on 
manufacturing  operations.  A  classification  of  labor  charges  for 


THE  INCOME  SHEET  565 

purposes  of  the  management  is  necessary.  The  same  thing 
may  be  said  of  supplies  and  in  fact  of  all  items  which  are  used 
indiscriminately  for  various  purposes ;  for  it  is  essential  finally 
to  charge  each  item  to  an  expense  account  representing  the 
function  for  which  it  is  used. 

This  simply  means  that  a  measurement  of  the  separate  asset 
items  consumed  does  not  constitute  in  all  cases  a  complete 
classification  of  expense  accounts  which  is  adequate  for  man- 
agerial purposes.  What  does  constitute  an  adequate  classifica- 
tion depends  on  the  needs  of  the  individual  manager.  It  is  quite 
generally  recognized  that  a  functional  classification  is  most 
desirable,  and  therefore  a  list  of  the  various  functions  necessary 
to  the  production  of  the  commodity  or  service  should  be  drawn 
up  and  then  one  expense  account  kept  for  each  function.  This 
necessitates  a  considerable  use  of  internal  accounting  entries. 
Purchases  are  first  charged  to  sundry  asset  accounts  and  then 
as  the  items  are  used  charges  are  made  to  the  proper  expense 
accounts.  The  extent  to  which  such  a  policy  should  be  carried  is 
a  question  of  expediency,  and  the  controlling  consideration  is 
the  use  to  which  the  resulting  information  may  be  put  by  the 
manager. 

Enough  has  been  said  to  show  the  difficulties  confronting 
one  in  outlining  an  expense  classification.  The  following  will 
serve  to  illustrate  what  might  cover  the  situation  for  the  manu- 
facturing concern  whose  income  sheet  was  shown  on  page  559. 

Manufacturing  Expenses  — 

Materials  $1,895,365 

Direct  labor  825,200 

Maintenance  of  factory  building  — 
Repairs  $165,300 

Depreciation  65,495  230,795 

Maintenance  of  factory  equipment  — 

Repairs  $215,350 

Depreciation  195,400  410,750 

Power  expenses  — 

Fuel  $185,400 
Labor  10,250 

Repairs  to  power  plant  8,175 

Depreciation  of  power  plant  95,300  299,125 


566 


PRINCIPLES  OF  ACCOUNTING 


Tools,  patterns  and  dies  used 

Supervision  — 
Salaries  of  factory  officials 
Office  supplies 
Maintenance  of  office  equipment 


$   485,300 


29,595 


Miscellaneous  factory  expenses 

Total  expenses  incurred  during  year 

Inventory  finished  goods  and  goods  in  process  Jan.  ist 

Inventory  December  3131 
Manufacturing  cost  of  goods  sold  per 
income  sheet 


18,418 


$4,194,548 
985400 

$5,179,948 
1,087,262 

$4,092,686 


Selling  Expenses  — 
Salaries 
Advertising 

Maintenance  of  sales  offices  — 
Repairs 
Depreciation 
Travelling  expenses 
Entertainment  of  customers 
Office  expenses 

Miscellaneous  selling  expenses 
Total  selling  expenses  per  income  sheet 


$5,200 
4,395 


$221,315 
205,420 


9,595 
25,875 
15,215 
25,400 

6,565 

$509,385 


Administrative  Expenses  — 
Salaries  of  officials 
General  office  expenses 


25,320 


Maintenance  of  general  office  equipment  — 

Repairs 

Depreciation 

Miscellaneous  general  office  expenses 
Total  administrative  expenses  per  income  sheet 


$5,200 
2,185 


7,385 
7,oi5 


$110,250 


This  shows  in  rather  brief  form  the  type  of  information 
desired  by  the  general  manager.  Each  account  supposedly  rep- 
resents one  class  of  expense  items  about  which  questions  of 
management  are  involved.  Comparisons  can  be  made  between 


THE  INCOME   SHEET  567 

the  various  items  on  successive  statements,  and  if  several  plants 
are  operated  by  one  concern,  between  the  various  operating 
units.  The  important  point  to  emphasize  is  that  the  schedule 
of  operating  accounts  is  drawn  up  by  or  at  least  for  the  manager. 


THE   CONSOLIDATED    INCOME    SHEET 

The  viewpoint  taken  in  discussing  the  preparation  of  the 
accounting  statements  as  well  as  in  the  discussions  of  accounting 
principles  has  been  that  of  the  business  enterprise.  This  is 
largely  a  legal  concept  and  while  it  is  fundamental  in  accounting 
records  for  certain  types  of  business  organizations  it  is  of  less 
importance  in  reporting  financial  statistics  than  is  the  concept 
of  a  complete  operating  unit.  The  holding  company  form  of 
organization,  for  example,  is  a  method  commonly  used  in  modern 
corporation  finance  to  combine  several  legally  separate  and  dis- 
tinct corporations  under  one  operating  organization  through 
stock  ownership.  Each  company  retains  its  corporate  existence 
and  hence  a  complete  set  of  accounts  is  maintained  for  each 
enterprise,  but  such  effective  control  is  exercised  over  the  opera- 
tions of  the  group  by  the  corporation  holding  the  capital  stock 
that  all  of  the  companies  may  be  looked  upon  as  one  organization. 
Large  railroad  systems  have  been  built  up  as  a  result  of  one  com- 
pany purchasing  the  majority  interest  in  the  capital  stock  issues  of 
many  small  companies.  The  same  tendency  has  been  evidenced 
in  industrial  concerns  such  as  the  steel  industry.  In  fact  wher- 
ever economies  may  be  effected  or  monopolistic  conditions 
attained  this  form  of  combination  has  been  resorted  to. 

Since  the  accounts  are  of  the  individual  concerns,  such  com- 
binations in  no  way  affect  the  fundamental  accounting  practices. 
The  accounts  of  the  separate  corporations  are  kept  in  the  same 
way  after  as  before  the  establishing  of  the  holding  company.  For 
the  purposes  of  the  investor  in  the  holding  company,  however,  it 
is  desirable  to  make  an  income  sheet  for  the  operating  organiza- 
tion. This  shows  the  revenues  and  expenses  of  all  the  concerns 
as  a  whole.  On  the  basis  of  such  a  statement  the  investor  can 
judge  as  to  the  effectiveness  of  the  holding  company  form  of 
combination.  -Likewise  the  manager  desires  exhibits  of  operating 
accounts  as  of  the  whole  system  for  administrative  purposes. 


568 


PRINCIPLES  OF  ACCOUNTING 


The  preparation  of  such  statements  is  a  relatively  simple  matter, 
however,  as  it  is  only  necessary  to  add  up  the  items  of  like  char- 
acter in  the  income  sheets  of  the  separate  companies  to  produce 
what  is  called  a  consolidated  income  sheet. 

An  illustration  will  serve  to  show  how  such  a  statement  may 
be  used  by  the  investor  and  manager.  Suppose  that  the  A 
Company,  besides  operating  a  manufacturing  business,  owns  over 
fifty  per  cent  of  the  stock  of  the  B,  C  and  D  companies,  each  of 
which  is  engaged  in  the  same  or  a  like  business,  and  that  the 
following  represents  the  income  sheets  of  each  of  the  companies 
in  summary  form : 

A   Company 


Gross  revenue 

Expenses  — 

Manufacturing  $725,300 

Selling  115,250 

Administrative  95,400 

Operating  net  revenue 

Dividends  from  stock  of  B,  C,  and  D  owned 

Interest  on  investments 

Total  net  revenue 

Taxes 

Net  revenue  to  private  equities 

Interest  on  bonds 

Net  revenue  available  to  stockholders 

Dividends  declared 

Balance  carried  to  surplus 

B  Company 

Gross  revenue 

Expenses  — 

Manufacturing  $318,250 

Selling  85,200 

Administrative  9,800 

Operating  net  revenue 

Taxes 

Net  revenue  to  private  equities 
Interest  on  bonds 

Net  revenue  available  to  stockholders 

Dividends  — 

Amount  on  A's  holdings  $95,300 

Other  stockholders  5, 700 

Balance  carried  to  surplus 


$1,250,000 


935,950 
314,050 
425,300 
5,825 
745,175 


$    735,030 
385,295 

$    349,735 
285,300 

$      64,435 


$    625,400 


413,250 

$    212,150 

5,450 

$    206,700 

95,215 

$    111,485 


101,000 
$      10,485 


THE  INCOME   SHEET 


C  Company 

Gross  revenue 

Expenses  — 

Manufacturing  $1,250,000 

Selling  375)200 

Administrative  110,100 

Operating  net  revenue 

Taxes 

Net  revenue  to  private  equities 
Interest  on  bonds 

Net  revenue  available  to  stockholders 

Dividends  — 

Amount  on  A's  holdings  $    275,400 

Other  stockholders  65,300 

Balance  carried  to  surplus 


,175,300 


$    44o,ooo 

25,200 
$     414,800 

15,300 
$    399,5oo 


$   340,700 
$      58,800 


Gross  revenue 


D  Company 


Expenses  — 

Manufacturing  $  185,325 

Selling  I7,4i5 

Administrative  8,310 

Operating  net  revenue 

Taxes 

Net  revenue  to  private  equities 

Interest  on  bonds 

Net  revenue  available  to  stockholders 

Dividends  — 

Amount  on  A's  holdings  $    54,600 

Other  stockholders  42,400 

Balance  carried  to  surplus 


450,375 


211,050 

$    239,325 

6,480 

$    232,845 

78,310 

$    154,535 


97,000 

$      57,535 


A  consolidated  income  sheet  showing  the  operating  results  of 
the  combined  properties  would  be  as  follows  : 


570  PRINCIPLES  OF  ACCOUNTING 

Consolidated  Income  Sheet 

A  Company  and  Its  Subsidiaries 
Gross  revenue  $4,501,075 

Expenses  — 

Manufacturing  $2,478,875 

Selling  593,065 

Administrative  223,610  3.295,550 

Operating  net  revenue  $1,205,525 

Interest  on  investments  5,825 

Total  net  revenue  $1,211,350 

Taxes  47,275 

Net  revenue  to  private  equities  $1,164,075 

Interest  on  bonds  574,120 

Net  revenue  available  to  stockholders  $  589,955 

Dividends  on  stock  in  hands  of  public  398,700 

Balance  carried  to  surplus  $  191,255 

This  shows  the  income  sheet  as  it  would  look  if  the  various 
properties  were  legally  consolidated  into  one  corporation.  There 
are  few  questions  of  principle  involved.  Attention  should  be 
called  to  the  fact  that  inter-company  relations  in  so  far  as  possible 
have  been  eliminated.  The  dividends  earned  as  shown  on  the 
income  sheet  of  the  A  Company  were  also  shown  as  distributions 
on  the  subsidiary  companies'  income  sheets.  Hence,  in  con- 
solidating the  statements  these  items  were  omitted  altogether. 
If  they  had  been  included  it  would  be  an  operation  similar  to 
transferring  funds  from  one  pocket  to  another.  The  same  situa- 
tion would  probably  arise  in  connection  with  the  purchase  and 
sale  of  products  between  the  various  companies.  Company  C, 
for  example,  might  be  purchasing  products  from  B  Company 
at  a  price  high  enough  to  yield  a  profit.  The  part  of  such  profit 
which  accrues  on  the  stock  held  by  the  A  Company  is  both  an 
expense  and  a  revenue  in  the  consolidated  income  sheet.  There 
is  some  justification,  however,  for  not  attempting  to  eliminate  this 
element.  Not  only  would  it  be  extremely  difficult  to  determine 
the  amount  involved,  but  the  correction  is  automatically  made 
in  the  operating  division,  leaving  operating  net  revenue  at 
just  the  figure  it  would  be  if  the  profit  on  such  inter-company 
sales  were  eliminated.  The  consolidated  income  sheet  can  be 


THE  INCOME  SHEET  571 

analyzed  for  the  purposes  of  the  various  interested  parties  in 
much  the  same  way  as  the  ordinary  income  sheet  of  one  business 
concern. 

This  chapter  may  be  briefly  summarized.  The  historical 
data  furnished  by  the  expense,  revenue,  and  net  revenue  accounts 
can  be  placed  in  statement  form  in  any  number  of  different  ways 
for  the  purpose  of  bringing  out  clearly  different  kinds  of  in- 
formation. In  some  cases  it  will  be  in  compact,  brief  form,  in 
others  considerable  detail  is  included.  The  accountant  first 
determines  the  information  desired  and  then  presents  the  same 
in  such  form  that  it  can  readily  be  understood.  A  large  part  of 
the  practicing  accountant's  work  consists  in  compiling  classi- 
fications of  accounts.  A  few  typical  classifications  were  shown 
in  the  illustrations,  not  with  an  idea  of  presenting  a  complete 
system  to  be  adopted  in  any  one  business  enterprise,  but  rather 
to  suggest  the  essential  considerations  in  connection  with  the 
drawing  up  of  a  system  for  any  concern. 

The  surplus  sheet,  which  is  usually  appended  to  the  income 
sheet,  represents  the  changes  in  the  more  permanent  proprietary 
accounts.  This  statement  shows  the  accumulated  net  revenue 
from  date  of  organization  and  the  balance  appears  on  the  credit 
side  of  the  balance  sheet,  while  the  income  sheet  includes  only 
the  current  changes  in  equities  for  the  accounting  period.  The 
next  chapter  will  be  concerned  with  the  form  and  content  of 
the  balance  sheet. 


THE  GENERAL  BALANCE  SHEET 

THE  balance  sheet  is  the  foundation  of  the  accounting  struc- 
ture, as  was  shown  in  an  early  chapter,  and  it  has  therefore 
been  necessary  to  refer  repeatedly  to  this  statement  as  a  basis 
for  discussions  of  principle.  The  general  nature  of  the  balance 
sheet  and  the  type  of  information  conveyed  should  now  be 
thoroughly  understood,  but  it  still  remains  to  discuss  the  arrange- 
ment and  form  of  presentation  in  much  the  same  manner  as  was 
done  in  the  preceding  chapter  for  the  income  sheet. 


GENERAL  BALANCE  SHEET  CAPTIONS 

The  main  purpose  of  the  balance  sheet  is  to  present  a  state- 
ment of  the  financial  condition  of  a  business  enterprise  at  a 
stated  date.  For  this  purpose  a  simple  list  of  assets  on  the 
one  side,  and  of  equities  on  the  other,  would  be  sufficient.  But 
many  other  rather  important  questions  can  be  answered  by  a 
judicious  arrangement  of  items  into  groups,  each  representing  a 
separate  class  of  assets  or  equities.  The  importance  of  dis- 
tinguishing between  fixed  and  current  assets  in  a  balance  sheet 
has  already  been  sufficiently  emphasized,  and  in  Chapter  IX  a 
classification  of  accounts  under  each  group  was  shown.  In 
making  out  balance  sheet  reports  for  the  purposes  of  the  various 
interested  parties  the  items  shown  in  the  ledger  accounts  may  be 
combined  in  any  number  of  different  ways  in  order  to  bring  out 
different  kinds  of  information.  For  instance,  the  different 
items  entered  in  the  asset  column  of  the  ten-column  statement 
can  be  shown  under  very  few  heads  when  transferred  to  a  regular 
balance  sheet.  It  is  good  policy,  however,  to  explain  carefully 

572 


THE   GENERAL  BALANCE  SHEET  573 

the  nature  of  each  item  placed  in  the  balance  sheet  even  at  the 
risk  of  using  a  considerable  number  of  words. 

In  general,  the  nature  of  fixed  assets  is  clearly  understood. 
All  property  items  of  a  permanent  character  are  included  in  this 
class,  though  the  test  of  permanency  is  a  matter  of  judgment. 
Usually  if  the  item  lasts  for  more  than  one  year  from  date  of 
purchase  it  is  considered  a  fixed  asset,  although  certain  types 
of  assets  which  are  retained  for  much  longer  periods  are  com- 
monly placed  among  the  current  assets.  In  any  case,  it  is 
assumed  that  the  fixed  assets  represent  the  more  permanent 
forms  of  investment  made  by  the  long-term  security  holders. 

In  making  up  a  balance  sheet,  all  fixed  assets  may  be  put 
into  one  figure  for  certain  purposes.  Usually,  however,  it  is 
much  better  to  state  definitely  the  amount  representing  fixed 
tangible  assets  under  one  head,  fixed  intangibles  under  another, 
and  securities  held  for  investment  purposes  under  a  third. 
These  are  three  significant  classes  of  fixed  assets  and  even  in 
the  most  abridged  balance  sheets  should  be  shown  separately. 
In  thus  separating  these  items,  the  balance  sheet  states  that  a 
certain  amount  of  the  capital  investment  is  in  the  form  of  physical 
property,  a  certain  amount  in  intangibles  —  such  as  goodwill, 
and  finally  a  certain  amount  in  the  securities  of  other  corpora- 
tions. If  an  income  sheet  is  available,  it  is  possible  to  determine 
with  a  reasonable  degree  of  accuracy  the  propriety  of  the  valua- 
tions made.  Net  revenue  from  operation  divided  by  the  total 
valuation  of  tangible  and  intangible  assets  should  give  a  per- 
centage figure  at  least  equal  to  the  normal  rate  for  the  type  of 
business  involved.  In  case  it  is  less  than  this,  the  valuation  of 
the  intangibles  is  excessive.  The  extent  of  the  over-valuation 
can  clearly  be  seen  if  the  two  types  of  assets  are  shown  under 
separate  headings.  This  is  the  legitimate  objection  to  using 
such  a  general  caption  as  plant,  machinery,  land,  goodwill, 
patents,  etc.,  to  cover  the  fixed  assets.  So  also  the  separate 
statement  of  the  net  revenue  from  investments  will  show  whether 
the  valuations  placed  on  investments  are  justifiable. 

The  first  classification  of  balance  sheet  headings  under  fixed 
assets  then  should  be  on  the  basis  of,  (i)  physical  property, 
(2)  intangible  assets,  and  (3)  long-term  claims.  Each  of  these 
groups  may  be  subdivided  in  more  extensive  balance  sheets  as 


574  PRINCIPLES  OF  ACCOUNTING 

need  arises.  Thus,  tangible  assets  may  be  divided  into  build- 
ings, land,  machinery,  and  other  equipment.  Such  a  classi- 
fication serves  to  show  the  relative  importance  of  the  different 
kinds  of  fixed  physical  property  used.  Each  of  these  classes 
should  be  divided  in  much  more  detail  for  the  purposes  of  the 
management.  This  is  a  functional  classification. 

Another  basis  for  classification  of  fixed  assets  would  be  the 
kinds  of  business  done.  Thus  in  the  case  of  a  company  which 
furnishes  both  electric  and  gas  service  to  a  community  it  would 
be  well  to  list  among  the  fixed  assets : 

Physical  equipment  —  electric xxxx 

Physical  equipment  —  gas xxxx 

Then  if  the  income  sheet  is  also  classified  on  this  basis,  the  rate 
of  return  on  each  form  of  property  is  available.  In  this  case  a 
functional  classification  for  each  plant  should  be  available  for 
managerial  purposes. 

An  important  consideration  to  be  observed  in  classifying  the 
balance  sheet  accounts  is  to  follow  as  far  as  possible  the  cor- 
responding income  sheet  divisions,  so  that  judgments  as  to  the 
effective  use  of  particular  items  of  the  investment  can  con- 
veniently be  made. 

Current  assets  consist  of  all  the  property  items  which  are 
currently  consumed  or  are  of  a  liquid  character.  It  is  generally 
a  poor  policy  to  list  all  current  items  in  one  figure  on  the  balance 
sheet.  Certain  current  items  such  as  accounts,  notes  receivable, 
and  cash,  are  quite  liquid  and  may  be  used  to  meet  the  current 
liabilities.  These  constitute  one  class  which  should  be  listed 
separately.  Then  raw  materials  and  other  working  assets  which 
are  not  as  liquid  should  be  listed  in  another  group.  It  is  good 
finance  to  raise  practically  all  the  funds  needed  for  the  current 
liquid  assets  through  short-term  current  liabilities.  Hence  a 
comparison  between  these  items  is  of  importance.  On  the 
other  hand,  the  working  assets  which  remain  somewhat  longer 
in  the  business  process  should  be  obtained  through  more  perma- 
nent liability  obligations.  A  third  class  of  current  assets  closely 
resembling  the  working  assets  are  the  unexpired  claims  for 
services,  such  as  insurance  premiums,  unexpired  advertising, 
etc.  It  is  well  to  place  these  in  a  special  group. 


THE   GENERAL  BALANCE  SHEET  575 

A  final  class  of  items  on  the  asset  side  consists  of  valuation 
items.  This  includes  items  which  cannot  be  considered  as  true 
assets,  such  as  exceptional  losses  not  yet  charged  off,  and  ex- 
penses which  have  been  incurred  but  have  not  been  recognized 
in  expense  accounts.  In  this  group  will  also  be  placed  the 
valuation  accounts  such  as  Discount  on  Stock  and  any  other 
formal  deficit,  if  one  exists. 

The  classification  of  equity  items  is  somewhat  similar  to  that 
of  the  assets.  In  the  first  place  the  permanent  equities,  repre- 
sented by  stocks  and  bonds  outstanding,  are  listed  as  fixed 
capital.  These  usually  are  nearly  equal  in  amount  to  the  fixed 
assets. 

The  current  liabilities  consist  of  all  the  short-term  claims. 
It  is  good  policy  to  classify  these  items  into  those  which  must 
be  met  practically  on  demand,  such  as  notes  and  accounts  pay- 
able, and  those  which  accrue  over  a  relatively  long  period,  such 
as  accrued  interest  and  taxes. 

A  third  class  of  accounts  appearing  on  the  equity  side  of  the 
balance  sheet  consists  of  the  deferred  credit  items.  These  are 
usually  in  the  nature  of  suspense  accounts.  Examples  of  de- 
ferred credits  have  been  given  in  a  preceding  chapter.  A  typical 
case  is  the  unredeemed  coupon  account  in  the  case  of  a  company 
which  sells  coupon  books  in  advance  of  performing  the  service 
for  its  customers.  In  one  sense  the  unredeemed  coupons  may 
be  called  liabilities  to  the  holders.  Credits  are  made  to  revenue 
during  the  periods  in  which  the  coupons  are  presented  for  service, 
and  the  concurrent  charges  are  made  to  the  liability  account. 
The  valuation  accounts,  such  as  allowances  for  uncollectible 
accounts  and  for  depreciation,  should  be  set  off  in  a  separate 
group.  In  some  cases  it  would  be  proper  to  show  the  valuation 
items  as  deductions  from  the  specific  asset  items  on  the  other 
side  of  the  balance  sheet.  In  the  next  section  the  two  ways  of 
treating  valuation  items  will  be  shown. 

The  last  class  of  items  on  the  equity  side  consists  of  surplus 
and  proprietary  reserves,  and  these  are  added  to  the  capital 
stock  item  to  determine  total  proprietorship. 

Briefly  the  general  balance  sheet  captions  can  be  stated  in 
outline  form  as  follows : 


576  PRINCIPLES  OF  ACCOUNTING 

ASSETS 

Fixed: 

Tangible 
Intangible 
Long-term  claims 

Current : 

Liquid 

Working 

Sundry 

Deferred  debits 
Valuation  items 

Deficit 

EQUITIES 

Fixed: 

Capital  stock  (proprietary) 
Bonds  (liability) 

Current : 

Notes  and  accounts 

Accrued  items 
Deferred  credits 
Valuation  items 
Surplus  and  proprietary  reserves 

Further  subdivisions  of  groups  may  be  made  in  case  further 
details  are  desired.  The  classification  given  here  is  fundamental, 
however,  for  any  type  of  balance  sheet. 

ILLUSTRATIVE    BALANCE    SHEETS 

The  form  in  which  the  balance  sheet  information  should  be 
presented  depends  on  the  particular  phase  of  the  business  condi- 
tion which  it  is  desired  to  emphasize.  There  are  many  different 
forms  quite  generally  used  in  actual  practice.  In  fact  it  might 
be  well  to  prepare  a  series  of  balance  sheets  for  the  same  con- 
cern, giving  the  same  information  in  different  ways.  In  one 
case  the  ultimate  solvency  as  reflected  by  a  comparison  of 
fixed  assets  and  fixed  capital  might  be  the  most  important  fact 
to  be  disclosed.  In  such  a  case,  these  items  will  be  placed  first 
on  their  respective  sides  of  the  balance  sheet.  Immediate  sol- 


THE  GENERAL  BALANCE  SHEET 


577 


vency,  as  reflected  in  the  comparison  of  current  liquid  assets 
with  current  liabilities,  being  of  secondary  importance,  might 
be  shown  by  a  second  grouping.  The  deferred  debit  items  and 
valuation  accounts  would  complete  the  asset  side,  while  deferred 
credit  items  and  valuation  items  followed  by  surplus  and  pro- 
prietary reserves  would  complete  the  credit  side.  This  form 
of  statement  has  been  quite  widely  adopted  and  may  be  found 
in  many  of  the  current  published  records  of  corporations.  On 
the  other  hand  it  may  be  felt  that  for  certain  purposes, 
immediate  solvency  conditions  should  be  shown  first  on  the 
balance  sheet.  In  this  case  the  order  of  the  items  would  be  just 
the  reverse  of  that  stated  in  the  preceding  case. 

The  following  is  an  illustration  of  a  balance  sheet  arranged 
according  to  the  first  plan  mentioned : 


ASSETS 


Fixed: 

Plant,  machinery,  equipment 
Patents,  trademarks,  designs 
Securities  of  subsidiaries 


Current  Working : 

Material  inventory 

Inventory  of  goods  in  process 
including  proportion  of  labor 
and  indirect  expenses 

Inventory  of  finished  goods 


Current  Liquid : 

Notes  receivable 

Accounts  receivable 

Cash 

Short-term  investments 


Deferred  Debits : 
Prepaid  rentals 
Unexpired  insurance,  etc. 


$2,498,794 

587,385 

1,385,476 


$   485,395 


325,400 
586,500 


$   675,300 
276,400 

125,375 
215,486 


35,400 
15,875 


$4,471,655 


1,397,295 


1,292,561 


Valuation  Items : 

Discount  on  bonds 

2P 


215,325 
$7,428,111 


578 


PRINCIPLES  OF  ACCOUNTING 


EQUITIES 


Fixed  Capital : 

Preferred  stock 
Common  stock 
Bonds 


Current  Liabilities : 
Notes  payable 
Accounts  payable 
Accrued  wages 
Taxes  accrued 
Interest  accrued 


Deferred  Credits : 
Prepaid  rentals 
Unredeemed  coupons 


Valuation  Items : 

Allowance  for  depreciation 
Allowance  for  doubtful  accounts 


Surplus  and  Proprietary  Reserves : 
Sinking  fund  reserve 
Reserve  for  contingencies 
Surplus 


$  525,000 
1,500,000 
1,500,000 


975,300 

585,400 

10,350 

8,400 

4,875 


5,875 
10,485 


$   655,750 
45,875 


$  185,400 
575,300 
840,101 


$3,525,000 


1,584,325 


16,360 


701,625 


1,600,801 
£7,428, ii i 


The  fixed  assets  are  placed  opposite  capital  liabilities,  in  order 
that  comparisons  between  these  two  classes  of  items  may  be 
readily  made.  In  this  illustration  the  former  exceed  the  latter 
by  a  considerable  amount  indicating,  in  case  conservative 
valuations  have  been  made,  that  the  ultimate  solvency  of  the 
concern  is  unquestionable.  A  comparison  of  the  current  liquid 
assets  with  the  current  liabilities  reveals  the  fact  that  there  may 
be  some  concern  as  to  the  immediate  solvency.  Current  liabilities 
are  considerably  in  excess  of  these  current  assets.  Such  compari- 
sons as  these,  while  not  conclusive,  indicate  in  a  general  way  the 


THE   GENERAL  BALANCE  SHEET  579 

condition  of  the  concern.  The  comparison  between  current 
assets  and  liabilities  is  of  especial  interest  to  bankers  and  other 
short-term  creditors.  As  has  been  shown  in  previous  connec- 
tions, a  large  part  of  the  circulating  capital  of  a  concern  is  raised 
through  the  use  of  bank  credit.  Such  comparisons  as  the  one 
last  considered  can  be  made  the  basis  of  a  reasonable  decision 
in  regard  to  the  granting  of  loans  by  banks. 

The  ultimate  solvency  as  revealed  in  the  first  comparison  is 
of  particular  interest  to  the  bondholders.  The  possibility  of 
loss  of  capital  in  case  of  foreclosure  is  shown  in  a  comparison  of 
the  fixed  assets  and  capital.  Of  course  the  bondholder  is  also 
interested  in  immediate  solvency  as  the  probability  of  receiving 
interest  installments  is  determined  by  this  condition. 

The  next  group  of  items  on  the  asset  side  consists  of  ac- 
counts representing  rights  to  services  which  are  unexpired. 
These  are  placed  under  the  general  heading  "deferred  debit 
items."  A  discussion  of  these  items  was  given  in  Chapter  X. 
These  are  items  held  in  suspense.  If  not  large  in  comparison 
with  the  total  assets  these  will  not  influence  materially  judgments 
as  to  either  immediate  or  ultimate  solvency. 

Finally  the  debit  valuation  accounts  complete  the  asset  side 
of  the  balance  sheet.  In  this  case,  discount  on  bonds  is  the 
only  item  included  in  this  group.  This,  as  has  already  been 
shown,  is  an  offset  to  the  bond  account  in  which  bonds  are  listed 
at  par. 

On  the  equity  side,  the  deferred  credit  items  consist  of  pre- 
paid rentals  and  unredeemed  coupons  in  this  illustration.  These 
again,  since  they  are  not  large  in  amount,  will  not  seriously 
affect  the  conclusion  drawn  with  respect  to  the  general  condi- 
tion. The  credit  valuation  items  are  offsets  to  certain  asset 
accounts.  The  allowance  for  depreciation  should  be  considered 
in  connection  with  the  various  fixed  assets  in  determining  the 
valuations  which  have  been  set  upon  these  items  by  the  officers 
of  the  company. 

There  is  considerable  force  in  the  argument  that  valuation 
accounts  should  be  deducted  from  the  accounts  affected  directly 
rather  than  placed  upon  the  opposite  side  of  the  balance  sheet. 
It  might  be  better,  for  example,  to  list  the  fixed  assets  as  shown 
in  the  balance  sheet  above  and  to  deduct  "allowance  for  de- 


580  PRINCIPLES  OF  ACCOUNTING 

preciation,"  carrying  the  balance  as  the  present  value  of  fixed 
assets.  It  can  be  readily  seen  that  this  would  give  a  much  more 
significant  figure  to  compare  with  the  fixed  capital  items.  At 
least  it  would  save  making  an  arithmetical  computation  before 
making  such  a  comparison.  Another  reason  for  deducting 
valuation  accounts  from  the  main  account  is  to  show  specifically 
the  nature  of  the  valuation  accounts.  Very  frequently  such  an 
account,  instead  of  being  called  "Allowance  for  Depreciation" 
is  called  "  Reserve  for  Depreciation."  It  is  but  natural  that  the 
individual  who  is  unfamiliar  with  accounting  technique  should 
confuse  these  accounts  with  surplus  reserves  or  even  with  funds. 
If  placed  on  the  asset  side  as  deductions,  such  confusion  is  less 
likely. 

The  last  group  of  accounts  shown  here  are  the  surplus  and 
proprietary  reserves.  These  show  the  additions  which  must  be 
made  to  capital  stock  in  order  to  determine  the  total  proprietor- 
ship. The  fact  that  several  proprietary  reserves  are  shown 
here  should  not  confuse  the  person  reading  the  balance  sheet. 
All  these  items  are  proprietary  accounts  and,  as  carried  in  total, 
should  be  definitely  called  "surplus."  This  item  is  of  par- 
ticular interest  to  the  stockholder  but  is  of  some  importance 
to  the  bondholder.  The  account  acts  as  a  buffer  for  the  claims 
of  all  permanent  security  holders. 

Balance  sheets  might  in  some  cases  be  separated  into  distinct 
parts  in  order  to  bring  out  clearly  the  comparison  which  it  is 
desired  to  make.  The  distinction  between  immediate  and  ulti- 
mate solvency,  for  example,  which  has  been  mentioned  frequently, 
might  be  shown  by  two  balance  sheets,  (i)  the  "  current  account  " 
balance  sheet  and  (2)  the  "  capital  account "  balance  sheet. 
The  current  account  statement  would  show  the  conditions  with 
respect  to  the  short-term  creditors,  while  the  capital  account 
balance  sheet  would  show  the  condition  of  the  permanent  in- 
vestment. On  pages  581  and  582  are  shown  illustrations  of  cur- 
rent and  capital  account  balance  sheets  respectively  for  the  com- 
pany whose  balance  sheet  was  shown  in  the  preceding  illustration. 

The  current  account  balance  sheet  here  shows  that  there  is 
an  excess  of  current  liquid  and  working  assets  over  current 
liabilities.  This  is  called  the  current  surplus.  This  is  significant 
in  showing  the  relation  between  the  assets  which  can  be  con- 


THE  GENERAL  BALANCE  SHEET 


Current  Account  Balance  Sheet 
Current  Liquid  Assets : 

Notes  receivable  $    675,300 

Accounts  receivable  276,400 

Cash  125,375 

Short-term  investments  215,486 

$1,29-2,561 
Less  allowance  for  doubtful  accts.  45,875 


Current  Working  Assets : 

Material  inventory  $   485,395 

Inventory  goods  in  process  325,400 

Inventory  finished  goods  586,500 


Deferred  Debits : 

Prepaid  rentals  $     35,400 

Unexpired  insurance,  etc.  15,875 


$1,246,686 


1,397,295 


2,695,256 


Current  Liabilities : 

Notes  payable  $   975,300 

Accounts  payable  585,400 

Accrued  wages  !o,35o 

Taxes  accrued  8,400 

Interest  accrued  4,875 


Deferred  Credits : 

Prepaid  rentals  $       5,875 

Unredeemed  coupons  10,485 

Current  Surplus 


$1,584,325 


16,360 

i,o94,57i 

$2,695,256 


Capital  Account  Balance  Sheet 
Fixed  Assets : 

Plant,  machinery  and  equipment 
Patents,  trademarks,  designs 
Securities  of  subsidiaries 


Less  allowance  for  depreciation 


$2,498,794 

587,385 
1.385,476 

$4,471,655 
655,750 


$3,815,905 


582  PRINCIPLES  OF  ACCOUNTING 

Fixed  Capital : 

Preferred  stock  $    525,00x3 

Common  stock  1,500,000 

Bonds  $1,500,000 

Less  discount  215,325  1,284,675 

$3,309,675 

Capital  Surplus  506,230 

$3,815.905 

Current  surplus  $1,094,571 

Capital  surplus  506,230 

Total  surplus  $1,600,801 

verted  into  cash  through  sale  within  a  relatively  short  time,  and 
the  liabilities  which  must  be  met  within  a  like  period.  Such  a 
statement  would  be  of  particular  importance  to  a  banker  at 
the  time  a  request  is  being  made  for  a  commercial  loan.  If 
the  banker  is  presented  with  an  income  sheet  showing  the  earn- 
ing conditions,  and  a  current  balance  sheet  showing  immediate 
solvency  conditions,  he  is  in  a  position  to  arrive  at  a  reasonable 
conclusion  as  to  the  propriety  of  extending  a  loan.  Some 
bankers'  associations  have  advocated  special  forms  of  reports 
for  this  purpose  and  on  each  of  these  provision  is  made  for 
making  just  such  comparisons  as  this  one.  Not  only  is  this 
important  for  the  banker's  purposes,  however,  but  the  manager 
also  should  have  just  such  statistics  available  for  determining 
the  feasibility  of  increasing  the  current  working  assets  through 
short-term  credit  or  through  floating  additional  securities.  The 
amount  of  current  capital  which  should  be  supplied  by  the  long- 
term  investor  as  compared  with  the  short-term  credit  is  always 
a  difficult  matter  to  determine,  ancl  such  a  balance  sheet  as  this 
would  aid  in  solving  this  question. 

The  second  of  these  balance  sheets  shows  the  relation  between 
the  fixed  assets  and  the  permanent  capital.  The  capital  surplus 
item  represents  the  excess  of  the  former  over  the  latter.  A 
healthy  condition  relative  to  ultimate  solvency  is  shown  when 
the  capital  surplus  is  large  in  amount.  Each  one  of  the  security 
holders  is  able  to  determine  from  such  a  statement  the  margin 
of  safety  for  his  capital  investment.  All  of  the  stockholders' 
equity  plus  the  capital  surplus  must  be  consumed,  for  example, 
before  the  bondholders'  is  touched.  A  capital  account  balance 


THE  GENERAL  BALANCE  SHEET         583 

sheet  could  very  well  be  used  for  prospectus  purposes  at  the 
time  of  issuing  new  securities.  It  would  be  of  little  use  alone, 
however,  without  the  current  balance  sheet,  as  the  stockholders' 
equities  suffer  before  even  the  current  liabilities.  In  the  illus- 
tration the  fact  that  a  surplus  is  shown  in  both  the  current  and 
capital  account  balance  sheets  indicates  a  healthy  solvency 
condition. 

The  sum  of  the  surplus  items  as  shown  in  the  two  balance 
sheets  constitutes  the  total  corporate  surplus.  A  considerable 
use  is  made  of  current  and  capital  account  balance  sheets  for 
corporations  in  England,  but  in  this  country  its  use  has  been 
restricted  mainly  to  the  balance  sheets  of  municipalities. 

It  is  often  difficult  to  determine  the  proprietor's  equity  in  the 
case  of  a  corporation,  especially  when  several  surplus  and  pro- 
prietary reserves  are  used.  The  proprietor's  equity  is  made 
up  from  the  accounts  showing  (i)  capital  stock,  (2)  surplus 
and  proprietary  reserves,  (3)  operating  deficit,  and  (4)  dis- 
counts and  premiums  on  capital  stock.  The  equities  of  all  the 
other  investors  and  creditors  are  shown  in  fewer  accounts.  The 
equity  of  the  bondholder,  for  example,  is  shown  in  the  bond  and 
discount  or  premium  accounts,  except  of  course  the  accrued  in- 
terest which  would  be  entered  in  another  account.  In  order 
to  bring  out  clearly  the  amount  of  the  proprietorship  in  the 
enterprise,  it  is  often  desirable  to  rearrange  the  balance  sheet 
in  some  other  form.  The  following  is  a  copy  of  a  balance  sheet  of 
a  well-known  rubber  company,  which  was  sent  out  for  advertising 
a  new  issue  of  preferred  stock.  A  series  of  about  ten  balance 
sheets  in  this  form  was  given  in  parallel  columns  for  compara- 
tive purposes,  but  only  the  one  for  1917  is  shown  here.  (See 
top  of  next  page.) 

It  will  be  noticed  that  the  company  first  emphasized  the  total 
assets  and  next  the  total  li abilities.  The  total  liabilities  were 
then  deducted  from  the  total  assets  and  the  balance  was 
designated  "excess  of  assets  over  liabilities."  The  point  which 
it  was  desired  to  emphasize  was  the  fact  that  the  proprietor's 
equity  was  approximately  three  times  as  large  as  the  outstanding 
liabilities.  In  the  appended  statement  the  proprietor's  equity 
is  subdivided  according  to  the  amounts  shown  in  separate  ledger 
accounts.  Part  of  this  equity  is  represented  in  preferred  stock 


584                        PRINCIPLES  OF  ACCOUNTING 

BALANCE  SHEET,  X  RUBBER  COMPANY 

October  3ist,  1917 
Assets: 

Plant  and  equipment  $24,942,790.23 

Quick  assets  5I>°53,6S5-93 

Other  assets  6,566,145.38 

Total  assets  $82,562,591.54 

Liabilities : 

Bonds  None 

Other  liabilities  21,126,529.26 

Total  liabilities  $21,126,529.26 

Excess  of  assets  over 

liabilities  $61,436,062.28 

Capital  Stock : 

Preferred  $24,393,700.00 

Common  20,278,620.00 

Reserves  4,000,061.40 

Surplus  12,763,680.88 

$61,436,062.28 


outstanding,  part  in  common  stock,  and  the  remainder  in  surplus 
and  reserves.  An  analysis  of  a  statement  in  this  form  could  be 
used  by  a  prospective  purchaser  of  preferred  stock  in  estimating 
the  amount  of  risk  which  he  would  assume  in  this  concern. 
The  series  of  balance  sheets  mentioned  would,  of  course,  add 
materially  to  his  information.  The  comparative  balance  sheet, 
however,  will  be  discussed  in  the  next  chapter. 

CLASSIFICATION  OF  ASSET  ACCOUNTS 

In  the  illustrations  given  in  the  preceding  sections  the  balance 
sheets  were  presented  in  summarized  form.  This  is  justified 
where  it  is  desired  that  the  balance  sheet  should  convey  general 
information  with  respect  to  financial  condition  since  details  are 
not  desirable  for  this  purpose.  For  other  purposes,  however,  it 
is  essential  to  keep  rather  detailed  records  of  the  asset  accounts. 
The  manager,  for  example,  needs  to  know  not  only  that  the 
total  fixed  property  amounts  to  a  certain  figure,  but  also  the 
amount  of  the  investment  in  each  separate  kind  of  property 
owned.  That  is,  he  asks  the  amount  invested  in  a  particular 


THE   GENERAL  BALANCE  SHEET  585 

machine,  together  with  the  present  valuation  of  the  machine, 
as  shown  by  the  books.  In  the  same  way,  he  should  be  able 
to  determine  original  cost  and  present  book  value  of  all  of  the 
various  asset  items.  For  this  purpose  a  property  register  is 
usually  kept  entirely  separate  from  the  general  ledger  accounts. 
In  this  register  are  listed  all  of  the  various  kinds  of  property, 
showing  the  date  of  acquisition,  original  cost  and  probable 
service  life.  The  amount  of  depreciation  charged  to  expense 
for  each  class  of  property  is  also  shown  in  such  a  way  that  the 
present  value  of  each  item  can  be  determined  by  reference  to 
a  register.  The  total  of  the  cost  figures  in  the  property  register 
should  equal  the  total  of  the  fixed  tangible  asset  items  on  the 
balance  sheet.  The  total  of  the  amounts  charged  to  deprecia- 
tion for  each  piece  of  property  should  equal  the  total  reserve 
for  depreciation.  In  other  words,  the  property  account  as 
shown  on  the  balance  sheet  is  a  controlling  account  for  the  cost 
figures  of  the  property  items  on  the  property  register.  Also, 
reserve  for  depreciation  is  a  controlling  account  for  the  valua- 
tion accounts  for  the  various  kinds  of  property.  In  the  annual 
reports  of  some  companies  transcripts  of  such  property  registers 
are  given  to  support  the  balance  sheet  figures.  In  the  case  of 
public  utilities  such  records  are  of  some  importance  in  connec- 
tion with  determining  the  reasonable  rate  base. 

The  intangible  asset  accounts  cannot  usually  be  classified 
under  sub-heads  as  readily  as  can  the  tangible.  The  reason  for 
this  is  evident.  Intangibles  in  the  case  of  industrial  concerns, 
at  least,  depend  on  the  earning  capacity  and  can  be  placed  in 
one  item  such  as  goodwill.  In  the  case  of  public  utilities,  how- 
ever, there  may  be  several  intangible  items.  Interest  during 
construction,  going  value,  franchise  value,  etc.,  may  be  entirely 
distinct  types  of  assets  and  in  such  a  case  separate  ledger  ac- 
counts should  be  kept  for  each  type,  although  the  total  of  all  may 
be  carried  on  the  balance  sheet  under  the  heading  "intangible 
assets."  It  is  evident  that  records  must  be  kept  of  the  different 
types  of  securities  listed  among  the  fixed  assets.  If  separate 
ledger  accounts  are  not  kept  the  securities  themselves  are  kept 
in  such  a  file  that  details  concerning  the  different  kinds  of  secu- 
rities are  readily  available.  The  importance  of  this  knowledge 
is  evident  particularly  in  the  case  of  holding  companies  where 


586  PRINCIPLES  OF  ACCOUNTING 

the  question  often  arises  as  to  the  valuation  of  the  securities  held. 
Among  the  current  assets  the  schedules  of  materials,  goods  in 
process,  and  finished  goods  are  of  importance  to  the  manager. 
He  should  have  some  form  of  register  of  raw  materials,  showing 
the  amount  on  hand,  the  amount  purchased,  and  the  amount 
put  in  the  process  of  manufacture.  The  Materials  account  in 
the  general  ledger  is  a  controlling  account  of  such  a  register. 
The  same  information  should  be  available  for  goods  in  process 
and  for  finished  goods.  A  record  of  finished  goods  should  be 
available  for  the  purpose  of  outlining  production  and  sales  policies. 
This  classification  is  for  the  purposes  of  the  manager  and  should 
be  constructed  to  meet  his  problems. 


XXVII 

COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS 

THE  form  and  content  of  the  balance  sheet  together  with  a 
brief  analysis  of  the  balance  sheet  items  were  discussed  in  the 
last  chapter.  Comparisons  between  items  on  successive  balance 
sheets,  however,  are  so  often  the  only  source  of  analysis  open  to 
the  investor  that  it  seems  advisable  to  stress  the  comparative 
balance  sheet  with  respect  to  the  proper  analysis  of  the  various 
items  by  the  present  or  prospective  investor.  By  considering 
such  statements  from  this  point  of  view  it  is  hoped  that  their 
general  as  well  as  their  specific  functions  may  be  better  under- 
stood. This  is  also  the  case  with  the  specific  forms  known  as 
consolidated  balance  sheets. 

THE  COMPARATIVE  BALANCE  SHEET 

It  has  been  stated  that  the  income  sheet  furnishes  a  historical 
exhibit  of  the  operation  of  the  business  for  a  period  of  time,  while 
the  balance  sheet  furnishes  a  statement  of  the  momentary  finan- 
cial condition.  Even  without  the  aid  of  an  income  sheet,  how- 
ever, a  comparison  of  two  balance  sheets,  one  taken  at  the  be- 
ginning of  a  period  and  one  at  the  end,  may  throw  considerable 
light  on  the  intervening  period.  This  fact  is  of  considerable 
importance  especially  where  published  statements,  without  ac- 
companying income  sheets,  furnish  a  series  of  balance  sheets. 
The  following  comparative  balance  sheet  for  the  X  Company 
furnishes  the  basis  for  a  discussion  of  the  use  of  such  a  state- 
ment. (See  next  page.) 

The  amount  of  proprietorship  is  of  primary  importance.  The 
common  stock  $700,000,  preferred  stock  $500,000,  sinking  fund 
reserve  $25,000,  and  surplus  $239,115  give  a  total  of  $1,464,115 
for  the  proprietary  accounts  listed  on  the  equity  side  for  the  year 

587 


538 


PRINCIPLES  OF  ACCOUNTING 


COMPARATIVE  BALANCE  SHEET  FOR  THE 
X  COMPANY,  FOR  DECEMBER  3151 


Fixed  Assets : 

Real  estate 

Buildings 

Machinery  and  tools 

Goodwill 

Securities  held  for  investment 

Working  Assets : 
Materials 

Goods  in  process  and  on  hand 
Supplies 

Liquid  Assets : 

Investments  in  sinking  fund 

Cash 

Accounts  receivable 

Deferred  Charges : 

Unexpired  insur.  and  advertising 

Valuation  Items : 

Loss  on  abandoned  property 
Discount  on  bonds 
Discount  on  stock 


Capital  Equities : 

Common  stock 
Preferred  stock 
Bonds 

Current  Equities : 

Notes  payable 
Accounts  payable 

Deferred  Credits : 
Rent  prepaid 

Valuation  Items : 

Allowance  for  depreciation 
Allowance  for  uncollectible  accounts 

Surplus  and  Proprietary  Reserves : 

Reserve  for  additions  and  betterments 

Sinking  fund  reserve 

Surplus 


1916 

$  150,000 
325,000 
425,000 
100,000 
115,000 

220,000 
180,000 

20,000 

IO,OOO 
230,000 
2IO,OOO 

2,600 

50,000 

18,215 

4O,OOO 

$2,095,815 


7OO,OOO 
5OO,OOO 
4OO,OOO 

100,000 

80,000 


1917 

$  175,000 
315,000 
5IO,OOO 
IOO,OOO 
315,000 

23O,OOO 

3OO,OOO 

15,000 

2O,OOO 
27O,OOO 
225,000 

2,200 

50,000 

16,400 

2O,OOO 

$2,563,600 

$  700,000 
550,000 

335,000 

360,000 
255,000 


50,000 

72,000 

500 

TOO 

2OO,OOO 

25,000 

50,000 

239,115 

40,300 

$2,095,815 


$2,563,600 


COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS    589 

1916.  The  valuation  items,  loss  on  abandoned  property  $50,000 
and  discount  on  stock  $40,000,  as  shown  on  the  asset  side,  de- 
ducted from  this  total  leaves  $1,374,115  as  the  net  proprietorship 
for  that  year.  For  1917,  the  net  proprietorship  is  stated  at 
$1,470,300.  The  same  accounts  are  included  in  the  computation 
in  finding  this  figure  with  the  addition  of  Reserve  for  Additions 
and  Betterments  account,  $200,000.  The  increase  in  proprietor- 
ship is  $96,185.  How  did  this  increase  come  about?  Clearly  it 
must  have  come  either  from  new  investment  or  profits  retained 
in  the  business.  An  investor  in  this  company  would  wish  to 
know  the  source  of  this  increase. 

There  are  three  possible  explanations  in  this  case,  depending 
on  the  type  of  transaction  which  caused  the  increase  in  preferred 
stock.  In  the  first  place  if  the  $50,000  of  preferred  stock  was 
issued  to  retire  the  same  amount  of  bonds,  this  increase  does  not 
represent  profits.  The  total  profits  retained  in  the  business  in 
this  case  would  be  $46,185.  In  the  second  place,  if  the  $50,000 
additional  preferred  stock  were  an  issue  of  new  stock  for  cash, 
the  increase  was  not  due  to  retained  surplus  in  the  business  and, 
as  in  the  first  case,  the  actual  amount  retained  during  this  period 
was  $46,185.  In  the  third  place,  a  preferred  stock  dividend 
might  have  been  issued.  If  this  were  the  case,  the  $50,000  would 
not  represent  an  actual  decrease  in  surplus  and  the  total  increase 
in  proprietorship,  $96,185,  would  represent  net  income  retained 
in  the  enterprise.  The  average  investor  would  be  familiar  enough 
with  the  business  to  know  which  one  of  these  cases  was  the  actual 
one.  For  the  purposes  of  the  rest  of  this  discussion  it  will  be 
assumed  that  the  first  of  these  possibilities,  namely  the  exchange 
of  stock  for  bonds,  was  the  actual  one. 

The  amount  of  proprietary  net  revenue  can  be  ascertained  with 
some  degree  of  accuracy  if  the  dividends  paid  are  known.  Sup- 
pose, for  example,  that  six  per  cent  or  $30,000  had  been  paid 
during  the  year  on  preferred  stock,  and  that  seven  per  cent  or 
$49,000  had  been  paid  on  common  stock.  In  this  case  the  in- 
crease in  the  proprietary  accounts  as  shown  in  the  comparative 
balance  sheet  plus  the  amount  of  dividends  paid  amounts  to 
$125,185.  This  can  reasonably  be  taken  for  the  proprietary  net 
revenue.  Of  course  if  adjustments  had  been  made  to  surplus, 
these  would  not  have  been  taken  into  consideration  in  this  item. 


5QO  PRINCIPLES  OF  ACCOUNTING 

But  in  the  average  case  such  a  computation  would  yield  a  sig- 
nificant figure.  It  will  be  noticed  that  this  figure,  1 25,185,  divided 
by  1,250,000,  the  par  value  of  the  stock  outstanding,  gives  a  rate 
of  about  ten  per  cent.  This  information  is  of  importance  to  the 
stockholders. 

The  totals  of  the  balance  sheet  were  $467,785  larger  in  1917 
than  in  1916.  Further,  it  was  assumed  that  no  new  investment 
of  fixed  capital  had  been  made.  The  valuation  accounts  were 
increased  by  $21,600.  After  deducting  this  increase  from  the 
total  increase  there  remains  $446,185,  still  to  be  accounted  for. 
It  is  evident  that  this  increase  could  come  about  only  from  one 
of  two  sources,  increased  surplus  or  increased  current  liabilities. 
The  total  surplus  increased,  as  shown  above,  by  $46,185.  Fifteen 
thousand  dollars  of  this  as  will  be  shown  later  was  used  for  retiring 
bonds.  Further,  $20,000  of  this  increased  surplus  was  used  to 
offset  stock  discount.  That  is,  the  stock  discount  account  was 
decreased  by  $20,000  and  this  could  only  result  from  a  charge 
against  surplus.  Therefore  only  $11,185  °f  this  iotal  came 
about  through  retained  surplus.  The  remainder,  $435,000,  was 
caused  by  an  increase  in  current  liabilities.  This  may  be  verified 
by  showing  that  the  current  liabilities  actually  increased  by  this 
amount.  What  was  done  with  the  funds  obtained  through  this 
increase  of  current  liabilities  ?  It  may  be  seen  that  current  liquid 
assets  were  also  increased  by  $65,000  and  working  assets  by 
$125,000,  therefore  the  total  increase  in  current  assets  is  $190,000, 
as  compared  with  the  increase  in  current  liabilities  already  men- 
tioned. The  balance,  $245,000,  must  necessarily  be  invested  in 
more  permanent  property.  The  policy  of  using  assets  obtained 
through  current  liabilities  for  permanent  property  is  questionable. 
If  carried  too  far,  it  is  bound  to  finally  result  in  jeopardizing  cur- 
rent solvency.  In  the  case  at  hand,  however,  since  the  total  of 
all  current  assets  exceeds  the  current  liabilities,  the  company 
cannot  be  so  severely  criticized.  The  point  to  be  made,  is  that 
one  should  inquire  into  the  situation  in  analyzing  a  comparative 
balance  sheet.  This  would  be  of  particular  importance  to  a 
banker  about  to  make  a  loan  to  the  corporation. 

A  further  analysis  will  reveal  the  fact  that  it  is  the  policy  of 
this  concern  to  use  its  sinking  fund  assets  for  the  purpose  of 
buying  back  its  own  bonds.  The  Sinking  Fund  Reserve  on  the 


COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS     591 


equity  side  was  increased  by  $25,000  while  the  sinking  fund 
assets  were  only  increased  $10,000.  The  other  $15,000  must 
have  been  used  for  retiring  $15,000  par  value  of  bonds.  The 
bonds  were  decreased  by  $65,000.  It  has  already  been  shown 
that  $50,000  of  this  was  caused  by  converting  bonds  into  pre- 
ferred stock.  The  other  $15,000  is  explained  by  the  investment 
of  these  sinking  fund  assets. 

Thus  it  may  be  seen  that  such  comparisons  from  comparative 
balance  sheets  shed  considerable  light  on  the  business  operation. 
Of  course,  it  is  impossible  always  to  state  that  a  special  asset  was 
used  for  a  particular  purpose  or,  conversely,  that  funds  obtained 
through  increases  in  special  equities  were  used  for  other  particular 
purposes,  but  reasonably  certain  conclusions  may  be  drawn  as 
to  actual  transactions,  as  was  done  in  this  analysis.  It  is  con- 
venient in  making  such  comparisons  to  list  the  changes  in  parallel 
columns. 


SOURCES  FROM  WHICH  ASSETS 
WERE  OBTAINED 


Buildings 

Supplies 

Unexpired  advertising 

Discount  on  bonds 

Discount  on  stock 

Preferred  stock 

Notes  payable 

Accounts  payable 

Allowance  for  depreciation 

Reserve  for  A  and  B 

Sinking  fund  reserve 


10,000 

5,000 

400 

1,815 

20,000 

50,000 
26o,OOO 
175,000 

22,OOO 
2OO,OOO 

25,000 


$769,215 


UTILIZATION  OF  THE  ASSETS 

Real  estate  $  25,000 

Machinery  and  tools  85,000 

Securities  200,000 

Materials  10,000 

Goods  in  process  120,000 

Sinking  fund  invest.  10,000 

Cash  40,000 

Accounts  receivable  15,000 

Bonds  65,000 
Allowance  for  doubtful 

accounts  400 

Surplus  198,815 

$769,215 


In  the  first  column  are  listed  all  the  accounts  which  show  by 
comparison  of  the  balance  sheets  either  decreases  in  asset  items 
or  increases  in  equities.  This  column  is  headed  "  sources  from 
which  assets  were  obtained."  It  is  assumed  in  making  this 
heading  that  in  ordinary  business  operation,  if  one  asset  decreases 
over  a  period  this  explains  the  receipt  of  another  asset  of  equal 
amount.  Also,  each  increase  in  an  equity  is  accompanied  by  an 
increase  in  an  asset  of  equal  amount.  In  the  second  column  are 


592  PRINCIPLES  OF  ACCOUNTING 

listed  all  increases  in  asset  items  and  decreases  in  equity  items. 
This  column  is  headed  "utilization  of  the  assets."  It  is  assumed 
that  an  asset  can  be  increased  only  through  the  utilization  of 
some  other  asset  and  that  equities  are  decreased  through  the  use 
of  assets. 

The  assumptions  involved  in  these  headings  are  not  entirely 
logical,  for  in  the  first  place  decreases  in  assets  may  result  in  de- 
creases in  equities,  and  increases  in  assets  may  be  the  result  of 
increases  in  equities.  As  these  cases  are  not  covered  in  the  rules 
given  the  headings  in  this  statement  are  somewhat  misleading, 
but  the  items  listed  in  the  left-hand  column  may  be  grouped  in 
one  category  and  those  in  the  right-hand  column  in  another  for 
the  purpose  of  analyzing  the  balance  sheet.  Some  accountants 
make  a  statement  of  this  sort  an  end  in  itself,  but  it  can  readily 
be  seen  that  such  statements  would  be  of  very  little  use  to  the 
average  investor  in  the  enterprise.  This  statement  is,  in  fact,  a 
mere  tool  to  be  used  in  analyzing  balance  sheet  items.  The  com- 
parisons which  were  discussed  in  the  preceding  paragraphs  could 
be  obtained  quite  readily  from  this  statement,  and  it  is  the  com- 
parisons that  are  ultimately  desired.  This  method  of  analyzing 
comparative  balance  sheets  is  convenient  in  reading  the  published 
reports  of  corporations. 

THE  CONSOLIDATED  BALANCE  SHEET 

The  holding  company  organization  has  already  been  mentioned 
in  previous  connections,  and  in  Chapter  -XXV  a  consolidated 
income  sheet  for  a  holding  company  was  shown.  Of  equal  im- 
portance to  the  consolidated  income  sheet  is  a  consolidated 
balance  sheet.  It  is  customary  for  the  holding  company  to  pre- 
pare a  balance  sheet  on  the  asset  side  of  which  are  listed  the 
securities  of  the  subsidiary  companies,  and  to  prepare  separate 
balance  sheets  for  each  of  the  subsidiary  companies.  This 
practice,  however,  obscures  the  fact  which  the  average  investor 
in  the  holding  company  desires  to  have  presented.  What  is  the 
condition  of  the  property  as  a  whole  which  is  under  the  control 
of  the  holding  company?  It  is  in  answer  to  this  question  that 
the  consolidated  balance  sheet  is  prepared.  This  consists  in  a 
combination  of  all  of  the  balance  sheets  of  the  holding  company 


COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS     593 

and  the  subsidiary  companies.  The  stock  of  the  subsidiary 
companies  is  not  carried  as  an  asset  in  this  case,  but  all  of  the 
assets  and  all  of  the  equities  are  combined  in  arriving  at  a  con- 
solidated balance  sheet. 

As  an  illustration  of  the  consolidated  balance  sheet,  suppose 
that  the  A  Company  has  purchased  a  controlling  interest  in  the 
B  and  C  companies  and  that  the  separate  balance  sheets  of  each 
are  as  follows : 

A  COMPANY 


Fixed : 


Assets 
Real  estate $  50,000 


Building  .  , 
Patents  .  , 
Machinery  .  , 
Stock  of  B  Co. 
Stock  of  C  Co. 


30,000 
25,000 
15,000 

55,000 
85,000 


Current : 

Merchandise $  25,000 

Advances  to  B  and  C 15,000 

Accounts  receivable 20,000 

Cash       5,000 


Equities 

Capital : 

Capital  stock 

Bonds  (secured  by  stock  of  B  and  C) 


$200,000 
50,000 


Current : 

Notes  payable $  25,000 

Accounts  payable 10,000 


Credit  Valuation  Items : 

Reserve  for  depreciation 
Surplus 


$260,000 


65,000 


$250,000 


35,ooo 


$325,000 


2Q 


594  PRINCIPLES  OF  ACCOUNTING 

B  COMPANY 

Assets 
Fixed : 

Real  estate $  25,000 

Buildings 20,000 

Patents 10,000 

Machinery 25,000 

Stock  of  C  Co 5,000 

$  85,000 
Current : 

Merchandise $  25,000 

Notes  receivable 10,000 

Accounts  receivable 8,000 

Cash 13,000 

56,000 
$141,000 

Equities 
Capital : 

Capital  stock $  75,000 

Bonds 50,000 

$125,000 
Current : 

Accounts  payable $    3,000 

Due  to  A  Co 5,ooo 

8,000 
Credit  Valuation  Items : 

Reserve  for  depreciation 5,ooo 

Surplus 3,000 

$141,000 
C  COMPANY 

Fixed:  Assets 

Real  estate $  15,000 

Buildings 25,000 

Patents 35,ooo 

Machinery 30,000 

$105,000 
Current : 

Merchandise $  20,000 

Notes  receivable 8,000 

Accounts  receivable 10,000 

Cash 15,000 

53,ooo 

$1=58,000 


COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS    595 

Equities 

Capital : 

Capital  stock $100,000 

Bonds 20,000 

$120,000 

Current : 

Accounts  payable $  3,ooo 

Due  to  A  Co 10,000 

13,000 

Credit  Valuation  Items : 

Reserve  for  depreciation    .......  12,000 

Surplus 13,000 

$158,000 


These  balance  sheets  show  the  condition  of  each  of  the  sep- 
arate companies.  In  order  to  show  the  condition  of  the  complete 
operating  unit,  the  consolidated  balance  sheet  will  be  given  under 
the  name  of  the  A  Company,  as  follows  : 


CONSOLIDATED  BALANCE  SHEET  OF  THE  A  COMPANY  AND  ITS 
SUBSIDIARIES 

Assets 

Fixed : 

Real  estate $  90,000 

Buildings 75>ooo 

Patents 70,000 

Machinery 70,000 

$305,000 

Current : 

Merchandise  ' $  70,000 

Notes  receivable 18,000 

Accounts  receivable 38,000 

Cash 33,000 

159,000 
$464,000 


596  PRINCIPLES  OF  ACCOUNTING 

Equities 

Capital : 

Capital  stock  (outstanding) $230,000 

Bonds 120,000 

$350,000 

Current : 

Notes  payable $  25,000 

Accounts  payable 16,000 

41,000 

Credit  Valuation  Items : 

Reserve  for  depreciation    .......  27,000 

Surplus 46,000 

$464,000 


There  are  several  points  which  require  consideration  in  prepar- 
ing such  a  statement.  All  inter-company  relations  of  a  debtor 
or  creditor  character  must  be  eliminated.  The  reason  for  this 
is  evident.  Among  the  current  assets  of  the  A  Company  is 
found  the  item  "Advances  to  B  and  C,  $15,000."  If  this  were 
considered  an  asset  on  the  holding  company's  balance  sheet,  the 
current  liabilities  "Due  to  A  Co.  $5,000,"  in  the  B  Company's 
balance  sheet,  and  $10,000  in  the  C  Company's  balance  sheet, 
would  necessarily  also  be  treated  as  liabilities  in  the  holding 
company's  balance  sheet.  In  other  words,  the  same  accounts 
would  be  both  assets  and  liabilities,  hence  these  advances  were 
eliminated  in  the  holding  company's  balance  sheet.  The  hold- 
ing company  often  issues  bonds  which  are  secured  by  the  stock 
of  the  subsidiary  companies.  In  the  illustration  $50,000  of  the 
A  Company's  bonds  were  issued  with  the  stock  of  the  B  and  C 
companies  as  collateral.  In  the  consolidated  balance  sheet 
the  bonds  of  the  A  Company  should  be  listed  among  the  equities, 
but  the  stock  of  the  B  and  C  companies  should  not  be  listed  as 
assets.  It  is  clear  that  while  the  bondholders  in  this  case  would 
claim  the  stock  in  case  of  insolvency  of  the  A  Company  the 
value  of  the  stock  would  depend  upon  the  assets  of  the  B  and  C 
companies.  The  consolidated  balance  sheet,  in  other  words, 
shows  on  the  one  hand  the  assets  owned  by  all  of  the  companies, 
and  on  the  other  side  the  equities  held  by  those  outside  of  the 
organization. 


COMPARATIVE  AND  CONSOLIDATED  BALANCE  SHEETS    597 

The  chief  advantage  of  the  consolidated  balance  sheet  lies  in 
the  fact  that  all  accounts  representing  inter-corporate  relations 
of  the  several  companies  have  been  eliminated.  Consolidated 
balance  sheets  for  many  of  the  large  corporations  are  published 
in  the  various  corporation  manuals.  The  following  are  the 
balance  sheets  of  the  American  Telephone  and  Telegraph  Com- 
pany, the  first  being  the  general  balance  sheet  of  the  company, 
the  second  being  the  consolidated  balance  sheet  of  the  entire 
system  for  1913 : 


GENERAL  BALANCE  SHEET 

American  Telephone  and  Telegraph  Company  * 

December  31 

Assets  1913 

Stocks  of  assoc.  cos $454,307,264 

Advance  to  assoc.  cos 76,677,615 

Telephones 14,279,678 

Real  estate      . 507,431 

Long  distance  telephone  plant 49,269,173 

Cash  and  deposits 22,199,228 

Spec,  demand  notes 34,311,230 

Accounts  receivable ,  j 4,404,689 

Total $655,956,308 


Liabilities  1913 

Capital  stock       $344,616,300 

Bonded  debt 159,591,000 

Coupon  notes 5,ooo 

Other  notes  payable 34,300,000 

Indebt'ness  to  West.  Un.  Tel.  Co 4,000,000 

Div.  payable  January  15 6,892,326 

Interest  and  taxes  accrued 3,091,571 

Accounts  payable 932,298 

Depreciation  reserve 36,836,187 

Surplus       65,691,626 

Total $655,956,308 

From  Moody's  Manual  of  Corporation  Securities,  for  1914,  page  2927. 


598  PRINCIPLES  OF  ACCOUNTING 

COMBINED  BALANCE  SHEET 

(Entire  System  in  United  States) 

December  31 

Assets  1913 

Telephone  plant $797,159,487 

Supplies,  tools,  etc 20,083,113 

Receivables 40,349,027 

Cash 31,888,858 

Stocks  and  bonds     .  • 90,523,610 

Total $980,004,095 

Liabilities  1913   • 

Capital  stock $395,224,531 

Bonded  debts 341,147,485 

Bills  payable       33,743,368 

Accounts  payable 26,471,681 

Employees'  benefit  fund  .     . 8,919,335 

Surplus  and  reserves 174,497,695 

$980,004,095 

In  the  first  of  these  statements  it  is  possible  to  obtain  but  little 
information  in  regard  to  the  telephone  and  telegraph  property 
directly  controlled  by  the  holding  company.  In  the  second 
statement,  however,  the  condition  of  the  operating  unit  as  a 
whole  is  shown.  From  this  statement,  for  example,  it  may  be 
seen  that  the  telephone  plant  controlled  by  the  company  is 
valued  at  $797,159,487  and  the  bonded  debt  of  this  property 
amounts  to  $341,147,485.  Further  information  in  regard  to  the 
combined  properties  is  available  from  this  statement. 


XXVIII 

STATEMENTS  OF  INSOLVENCY 

THE  income  sheet  and  balance  sheet  are  the  typical  forms  of 
statements  for  the  going  concern.  In  the  case  of  insolvency  or 
bankruptcy,  however,  some  special  forms  of  statements  are 
necessary.  No  new  problems  of  accounting  analysis  arise  in  these 
connections  but  the  statements  generally  prepared  are  sufficiently 
technical  to  warrant  a  brief  discussion  in  this  chapter. 

STATEMENT   OF   AFFAIRS 

A  statement  of  affairs  is  drawn  up  at  the  time  a  concern 
is  declared  insolvent,  for  the  purpose  of  indicating  the  probable 
amount  to  be  realized  by  the  various  creditors.  No  regulation 
form  has  been  universally  adopted,  but  the  court  generally 
demands  some  form  of  statement  from  the  receiver.  The  pro- 
cedure is  somewhat  as  follows.  A  receiver  is  appointed  to 
conduct  the  affairs  of  the  concern  on  the  date  that  it  is  declared 
insolvent.  It  is  his  function  to  wind  up  the  business,  convert 
the  assets  into  cash,  pay  off  the  creditors  according  to  their 
various  claims,  and  finally,  if  there  is  any  balance  left,  to  dis- 
tribute that  to  the  proprietors.  It  is  at  the  time  of  taking  up 
the  affairs  of  the  insolvent  concern  that  the  receiver  prepares  the 
statement  of  affairs.  This  is  made  on  the  basis  of  the  concern's 
own  balance  sheet,  as  of  the  same  date.  It  has  been  shown  in 
previous  connections  that  the  book  values  of  assets  to  a  going 
concern  are  greatly  in  excess  of  the  liquidation  values,  hence  an 
estimate  is  placed  on  the  probable  amount  to  be  realized  from 
each  asset. 

Next  an  investigation  is  made  of  the  nature  of  the  various 
claims  of  the  creditors.  Certain  claims  are  entirely  or  partly 

599 


6oo 


PRINCIPLES  OF  ACCOUNTING 


secured  by  specific  property  items.  These  liabilities  must  be 
deducted  from  the  valuations  of  the  specific  asset  accounts,  in 
order  to  determine  the  amount  available  for  unsecured  claims. 
Preferred  claims,  such  as  taxes  and  accrued  wages,  must  be 
shown  as  deductions  from  unencumbered  property  items  in  the 
proper  place.  All  of  this  information  can  be  placed  in  statement 
form.  In  order  to  show  the  procedure  more  concretely,  the 
balance  sheet  of  an  insolvent  concern  will  be  taken  as  the  basis 
for  a  statement  of  affairs. 


BALANCE  SHEET,  X  COMPANY 
May  31,  1918 


Assets 

Land 

Buildings 

Equipment 

Bills  receivable 

Accounts  receivable 

Finished  goods 

Raw  materials 

Cash 

Deficit 


Equities 


s 

135,200 

Common  stock 

320,224 

Preferred  stock 

482,052 

Bonds 

19,708 

Notes  payable 

13,867 

Accounts  payable 

165,247 

Accrued  taxes 

496,452 

Accrued  wages 

29,153 

170,412 

$1,832,315 


$  350,000 
350,000 
550,000 

318,600 

131,440 

16,875 

115,400 


$1,832,315 


In  addition  to  the  balance  sheet  of  the  corporation,  the  receiver 
ascertains  the  following  facts.  The  bonds  are  secured  by  a 
mortgage  on  the  land,  buildings,  and  equipment.  All  other  claims 
are  unsecured.  Taxes  and  wages  are  of  course  preferred  claims. 
It  is  estimated  that  the  land  will  bring  $140,000,  buildings 
$215,000,  and  equipment  $225,000  at  forced  sale.  Further  it  is 
estimated  that  the  bills  receivable  will  net  $16,708,  accounts 
receivable  $12,250,  finished  goods  $160,000,  and  raw  materials 
$230,000.  On  the  basis  of  these  facts,  the  statement  of 
affairs  exhibited  on  the  following  page  may  be  prepared. 

In  the  first  column  on  the  asset  side  are  placed  the  book  values 
of  all  assets  as  shown  on  the  balance  sheet.  The  total  of  this 
column  is  equal  to  the  total  of  the  asset  side  of  the  balance  sheet 
minus  the  deficit  item.  The  deficit  is  not  listed  in  this  statement, 


STATEMENTS  OF  INSOLVENCY 


60 1 


STATEMENT  or  AFFAIRS,  X  COMPANY 
May  31,  1918 


Assets  to  be  Realized 

BOOK  VALUE 

T 

Land  $    i3S,200 

Buildings  320,224 

Equipment  482,052 

Realizable  value  of  land,  bldgs.,  equip. 
Less  bonds  secured  by  mortgages 


Bills  receivable  19,708 

Accounts  receivable  I3,867 

Finished  goods  165,247 

Raw  materials  496,452 

Cash  29,153 

Total  $1,661,903 

Deduct  the  preferred  claims  — 

Accrued  taxes 

Accrued  wages 
Assets  available  for  distribution 

to  other  unsecured  creditors 
Deficiency 


ESTIMATED  REAL- 
IZABLE VALUE 
FOR  UNSECURED 

CREDITORS 

$I4O,OOO 

2I5,OOO 

225,000 

$580,000 

550,000 

$  30,000 

16,708 

12,250 

l6o,OOO 

230,000 

29,153 

$478,111 


$   16,875 
115,400 


$345,836 

104,204 

$450,040 


Liabilities  to  be  Liquidated 


Bonds  completely  secured  by 

mortgage 
Notes  payable 
Accounts  payable 
Accrued  taxes  (preferred  claims 

deducted  from  assets) 
Accrued  wages  (preferred  claims 

deducted  from  assets) 
Total 


BOOK  LIABILITIES 

$  550,000 
318,600 
131,440 

16,875 
H5.400 


CLAIMS 

ON  UNSECURED 
ASSETS 


$318,600 
131,440 


$1,132,315 


$450,040 


602  PRINCIPLES  OF  ACCOUNTING 

as  it  is  a  valuation  account,  an  offset  to  proprietorship.  On  the 
liability  side  in  the  first  column  are  listed  all  balance  sheet 
equities  with  the  exception  of  the  proprietary  items  —  common 
and  preferred  stock  in  this  case.  Proprietorship  accounts  are 
omitted  from  this  statement  entirely. 

Next,  the  amount  which  each  asset  is  estimated  to  realize  is 
set  down  in  a  second  column  on  the  asset  side.  In  case  any  such 
assets  are  pledged  as  security  for  specific  liabilities  the  particular 
liabilities  are  deducted  from  the  net  valuation  and  the  balance 
is  carried  to  the  column  headed  "  Estimated  realizable  value  for 
unsecured  creditors."  In  this  illustration,  only  one  such  case 
was  given.  The  bonds  were  secured  by  a  mortgage  on  the 
land,  buildings,  and  equipment,  hence  $550,000  for  bonds  was 
deducted  from  the  net  valuation  of  these  three  items  and  the 
balance  of  $30,000  was  carried  into  the  last  column. 

The  total  estimated  value  of  the  assets  available  to  meet  the 
claims  of  unsecured  creditors  amounts  to  $478,111.  The  claims 
of  the  preferred  creditors  (accrued  taxes  and  wages)  are  deducted 
from  this  figure.  This  leaves  a  net  amount  of  $345,836,  available 
to  unsecured  non-preferred  creditors.  In  the  second  column  on 
the  liability  side  the  unsecured  creditors'  claims  are  listed.  The 
total  of  this  column,  $450,040,  minus  the  unpledged  assets, 
$345,836,  shows  the  estimated  deficiency,  $104,204.  In  the  case 
of  a  corporation  this  loss  is  incurred  by  the  unsecured  creditors 
entirely  unless  some  specific  statute  allows  the  corporation  to 
assess  the  stockholders.  This  is  usually  not  the  case,  however. 
In  partnerships  or  single-proprietary  enterprises,  this  deficiency 
can  be  made  the  basis  of  suit  against  the  proprietors.  In  the 
illustration  all  of  the  proprietary  equity  is  lost  and  the  unsecured 
creditors  lose  the  $104,204. 

The  amount  which  each  creditor  will  probably  receive  is  found 
by  dividing  the  unsecured  assets,  $345,836,  by  the  unsecured 
claims,  $450,040.  This  gives  76.8  per  cent.  In  other  words 
each  of  the  unsecured  creditors  will  probably  realize  seventy-six 
and  eight-tenths  cents  on  the  dollar. 

The  last  column  on  the  asset  side  and  the  last  column  on  the 
equity  side  constitute  what  may  be  considered  a  type  of  balance 
sheet.  It  is,  in  fact,  a  forced  liquidation  balance  sheet.  It  is 
prepared  for  the  purposes  of  the  creditors  primarily  in  order  that 


STATEMENTS  OF  INSOLVENCY  603 

they  may  determine  with  some  degree  of  accuracy  the  extent  of 
their  losses  in  dealing  with  the  insolvent  firm.  The  statement 
shown  in  the  illustration  was  prepared  according  to  the  American 
form  of  balance  sheet,  —  assets  on  the  left-hand  side  and  liabilities 
on  the  right-hand  side.  Some  accountants  reverse  this  procedure 
and  place  liabilities  first  and  assets  second.  This  appears  to 
be  a  questionable  procedure.  One  author  suggests  that  the 
probable  reason  for  this  is  that  the  statement  of  affairs  is  of 
English  origin  and  that  the  American  accountants  who  favor  this 
form  are  simply  following  English  practice.1  It  is  logical  for 
the  English  accountants  to  use  this  form  inasmuch  as  liabilities 
are  listed  first  and  assets  second  on  the  balance  sheet.  A  logical 
procedure  in  constructing  American  statements  would  be  to 
place  assets  first  and  liabilities  second. 

DEFICIENCY    STATEMENT 

No  changes  are  made  in  the  ledger  accounts  at  the  time  of 
preparing  a  statement  of  affairs.  This  is  made  out  entirely  as 
an  estimate  to  be  used  for  the  purposes  of  judgment  as  to  the 
extent  of  deficiency.  The  receiver  then  winds  up  the  business, 
sells  the  assets  for  the  best  price  he  can  get,  pays  the  secured 
claims  from  the  proceeds  of  the  assets  pledged,  pays  the  preferred 
claims  and  finally  pays  what  is  left  to  the  unsecured  creditors. 
He  keeps  the  accounts  in  the  regular  form  and  finally,  at  the  time 
the  whole  business  is  liquidated,  makes  out  a  statement  showing 
the  results  of  receivership.  This  is  usually  in  the  form  of  a 
deficiency  statement. 

As  each  asset  is  sold  Cash  is  debited  for  the  proceeds  and 
Deficiency  account  is  debited  for  the  difference  between  book 
value  as  shown  by  the  last  balance  sheet  and  the  proceeds,  and 
the  particular  property  account  involved  is  credited.  In  case 
the  proceeds  exceed  the  book  value  of  an  asset  the  Deficiency 
account  is  credited  for  this  amount.  All  expenses  incurred  by 
the  receiver  together  with  his  own  fee  are  charged  to  this  account. 
The  amount  of  the  deficit,  as  shown  in  the  last  balance  sheet,  is 
debited  to  Deficiency  and  credited  to  the  Deficit  account.  The 

1  See  Hatfield,  Modern  Accounting,  page  335. 


604 


PRINCIPLES  OF  ACCOUNTING 


balance  in  the  Deficiency  account,  after  these  entries  have  been 
made,  represents  the  total  amount  of  loss  to  the  equities.  The 
stockholders'  equities  suffer  first,  and  therefore  an  entry  is 
made  debiting  Capital  Stock  and  crediting  Deficiency.  In 
case  the  Deficiency  account  still  shows  a  debit  balance,  this 
represents  a  final  net  insolvency  which  must  be  met  by  the 
unsecured  creditors.  If  the  amount  realized  on  the  assets  by 
the  receiver  actually  corresponds  with  the  estimate  in  the  state- 
ment of  affairs,  the  net  insolvency,  as  shown  by  the  Deficiency 
account,  will  be  greater  than  the  deficiency  item  in  the  statement 
of  affairs  by  the  amount  of  the  receiver's  expenses  and  fees.  For 
purposes  of  illustration  it  will  be  assumed  that  the  receiver  did 
realize  the  amount  shown  in  the  statement  of  affairs  (above 
section)  and  that  his  fee  is  $1,000  and  expenses  $1,500.  In  this 
case  the  deficiency  statement  would  be  as  follows  : 


DEFICIENCY  STATEMENT,  X  COMPANY 
August  31,  1918 

Losses  on  Realization  of  Assets : 

Buildings  $105,224 

Equipment  257,052 

Bills  receivable  3,ooo 

Accounts  receivable  Jj6i7 

Finished  goods  5,247 

Raw  materials  266,452 

Total  losses  $638,592 

Less  profit  on  sale  of  land  4,800 
Net  loss  on  assets 

Expenses  of  Realization : 

Receiver's  expenses  $1,500 

Fee  of  receiver  1,000 

Total  loss  and  expenses  of  realization 

Deficit  previously  reported  by  company 


Stockholders'  equities  to  meet  losses : 

Common  stock 

Preferred  stock 

Net  deficiency  (loss  to  unsecured 
creditors) 


$350,000 
350,000 


$633,792 


2,500 

$636,292 

170,412 

$806,704 


700,000 


$106,704 


STATEMENTS  OF  INSOLVENCY  605 

The  net  deficiency  shown  by  this  statement,  $106,704,  is  just 
$2,500  greater  than  the  deficiency  item  in  the  preceding  state- 
ment of  affairs.  This  statement  is  in  fact  an  income  sheet  for 
the  receiver.  He  has  shown  losses  and  gains  incident  to  the 
selling  of  the  assets  of  the  concern.  Some  accountants  have 
advocated  the  use  of  several  accounts  to  show  the  information 
contained  in  this  deficiency  statement.  Such  accounts  as 
"realization,"  "liquidation,"  "settlements,"  etc.,  are  often 
used.  It  may  be  that  in  special  cases  these  additional  accounts 
are  of  use,  but  in  the  average  case  the  one  given  in  the  illus- 
tration is  sufficient. 


PART   SIX 
SPECIAL  FIELDS  OF  ACCOUNTING 


XXIX 

COST  ACCOUNTING 

As  was  suggested  in  Chapter  I  the  problems  of  management 
give  rise  to  a  distinct  and  important  branch  of  accounting, 
namely,  cost  accounting.  In  the  preceding  chapters  the  discussion 
of  the  accounting  principles  has  been  concerned  primarily  with 
the  construction  and  analysis  of  accounts  from  the  standpoint 
of  the  general  interests  of  the  equities  involved  —  especially  the 
proprietary  equity  —  although  the  question  of  detail  classification 
and  comparison  for  managerial  purposes  has  been  introduced 
at  various  points.  In  the  present  chapter  a  brief  ^statement  of 

some  of  the  essential  features  of  cost  accounting  will  W  given. 

1 

THE   PROBLEMS    OF   MANAGEMENT 

» 

Evidently  the  manager  of  a  large  scale  and  complex  enterprise 
should  have  at  his  disposal  if  possible  more  extensive  statistical 
information  than  that  furnished  by  the  ordinary  system  of  double- 
entry  accounts.  It  is  true  that  the  ledger  accounts  and  the 
financial  statements  (especially  the  expense  and  revenue  state- 
ment) furnish  much  data  of  value  to  the  management,  and  that 
if  the  information  presented  by  the  expense  and  revenue  state- 
ment is  well  classified,  considerable  light  is  thrown  upon  the 
process  by  which  the  resulting  net  revenue  or  loss  is  attained. 
In  fact  even  the  amount  and  rate  of  net  revenue  provides  a 
crude  test  of  efficiency  through  comparison  with  the  similar 
items  of  other  establishments  in  the  same  field  of  industry,  and 
with  the  results  of  other  periods  of  operation  in  the  same  enter- 
prise. But  in  view  of  the  present  complexity  of  the  industrial 
situation  and  the  emphasis  upon  efficiency  such  information  is 
rather  inadequate  for  managerial  purposes.  From  an  ordinary 

2R  609 


6io  PRINCIPLES  OF  ACCOUNTING 

income  sheet  the  manager  can  get  little  clue  as  to  the  prospects 
of  maintaining  a  creditable  showing ;  and,  if  the  net  result  of 
operation  is  unfavorable,  it  is  likely  that  only  on  the  basis  of 
detail  classifications  of  expense  and  revenue  according  to  some 
appropriate  functional  plan  can  an  intelligent  investigation  as 
to  causes  be  made  and  rational  policies  seeking  to  remedy  the 
situation  be  formulated. 

What  are  the  more  important  questions  of  management  which 
one  may  seek  to  solve  with  the  aid  of  cost  accounts  and  cost 
analysis  ?  In  the  first  place  it  may  be  noted  that  many  business 
firms  produce  more  than  one  product.  In  such  cases  it  is  not 
sufficient  that  total  revenue  and  total  expense  be  correctly 
ascertained  and  compared.  The  expense  of  producing  each 
distinct  commodity  or  service,  and  the  revenue  accruing  from 
the  sale  of  the  same,  should  be  determined  if  possible.  This  is  a 
relatively  simple  matter  as  far  as  revenues  are  concerned  (see 
page  141),  but  usually  the  allocation  of  expense  to  a  particular 
line  of  product  is  (as  will  be  explained  a  little  later)  a  very  difficult 
problem.  In  so  far  as  such  a  classification  can  be  made,  how- 
ever, its  utility  in  directing  production  in  a  rational  manner  is 
evident.  Some  companies  have  discovered,  after  introducing 
a  cost  system,  that  one  or  more  products  were  being  produced 
at  a  loss.  This  fact  had  not  been  previously  recognized  because 
the  loss  thus  suffered  had  been  covered  by  profits  on  other  lines. 
Similarly  other  firms  have  discovered  that  by  specializing  in  a 
particular  direction  losses  could  be  turned  into  profits. 

While  this  is  the  day  of  specialization,  very  few  enterprises 
are  producing  a  single  commodity  or  service  and  hence  the 
problem  of  allocating  expenses  to  a  particular  line  of  product  is 
an  almost  universal  problem  of  management.  In  many  cases 
circumstances  are  such  that  the  production  of  a  number  of  prod- 
ucts is  unavoidable.  This  is  usually  the  case  where  "by- 
products" are  made.  In  such  cases  all  costs  are  more  or  less 
joint.  Even  in  these  situations  it  is  probably  true  that  some 
allocation  of  costs  is  possible  and  desirable.  It  may  be  that  in 
some  industries,  such  as  railroads,  the  problem  is  not  capable  of 
solution;  and  in  such  cases  cost  accounting  is  of  doubtful 
efficacy.  A  classification  of  expenses  in  terms  of  the  objects 
for  which  expenditures  are  made  may  be  all  that  is  possible 


COST  ACCOUNTING  6n 

in  certain  cases.  The  problem  of  expense  allocation  will  be 
further  considered  in  the  next  section. 

Although  an  enterprise  may  be  producing  but  a  single  product, 
cost  statistics  may  be  necessary  in  order  that  the  manager  may 
have  the  information  with  which  to  make  comparisons  as  to  the 
efficiency  of  like  productive  units.  If  the  enterprise  consists 
of  a  number  of  plants  performing  similar  functions,  the  general 
manager  will  wish  to  ascertain  the  relative  efficiency  of  each  of 
the  various  plants.  Obviously  this  cannot  be  determined  by 
inspection.  The  expenses  and  revenues  pertaining  to  each  plant 
must  be  segregated  if  the  cost  per  unit  of  product  from  each 
plant  is  to  be  ascertained.  Not  only  are  comparisons  between 
plants  necessary  in  such  a  case,  but  efficient  management  requires 
a  knowledge  of  the  comparative  performances  of  departments, 
production  centers,  and  even  individual  machines.  Even  a 
record  of  the  individual  performance  of  each  employee  is  desirable, 
for  such  information  is  of  importance  in  improving  labor  effi- 
ciency. Such  statistical  analysis  may  be  carried  very  far  in 
some  cases  —  indeed  far  beyond  accounting  in  any  proper  sense. 
There  is  always  a  point,  however,  at  which  the  advantage  to  be 
derived  from  detail  information  is  counterbalanced  by  the  diffi- 
culty and  cost  of  securing  the  information. 

Even  if  an  enterprise  is  producing  but  one  line  in  the  ordinary 
sense,  cost  analysis  may  be  of  utility  in  still  another  connection. 
The  determination  of  cost  per  order  or  job  is  often  a  matter  of 
considerable  importance.  The  ship-building  company,  for 
example,  turns  out  units  of  product  of  different  sizes,  design, 
and  cost ;  and  in  many  cases  each  unit  is  manufactured  according 
to  definite  specifications.  Similarly  the  building  contractor 
constructs  many  types  of  buildings,  the  printing  and  publishing 
house  makes  many  kinds  of  books,  and  the  engine  manufacturing 
company  produces  a  variety  of  types  of  engines.  In  all  these 
cases  an  analysis  of  costs  in  terms  of  specific  jobs  or  orders  may  be 
an  important  factor  in  determining  bids  and  in  taking  orders. 
The  price-making  function  of  cost  accounting  is  often  greatly 
exaggerated  by  cost  enthusiasts,  but  in  this  connection  the 
general  utility  of  such  statistical  information  is  evident.  Cost 
accounts  may  furnish  a  basis  for  bids  without  in  any  sense  deter- 
mining prices. 


612  PRINCIPLES  OF  ACCOUNTING 

In  connection  with  the  utilization  of  the  economic  resources 
at  the  disposal  of  the  manager  still  other  problems  of  importance 
arise.  What  are  the  proper  combinations  of  the  productive 
factors?  Or,  in  other  words,  what  is  the  most  effective  process 
in  view  of  all  the  market  conditions?  This  may  involve  a 
comparison  of  the  costs  of  various  methods  simultaneously  in 
use,  or  of  the  costs  of  methods  in  use  with  those  of  possible 
methods.  Many  products  can,  of  course,  be  produced  by  a 
number  of  processes.  The  manager  must  decide  as  to  which  is 
the  most  efficient.  Certain  castings,  for  example,  can  be  sawed 
with  hand  tools  at  a  simple  work  bench,  or  they  can  be  cut  by 
a  practically  automatic  milling  machine.  Which  process  should 
be  adopted?  One  method  employs  little  capital  and  a  large 
amount  of  current  labor.  The  other  process  makes  use  of  a 
high-priced  machine  and  little  direct  labor.  The  cost  per  unit 
of  output  by  each  method  should  be  ascertained.  If  labor  is 
relatively  high  in  price  the  second  method  may  give  a  lower 
cost  per  unit.  If  the  rate  of  depreciation  on  the  necessary  high- 
powered  machine  is  high  and  repair  and  other  maintenance 
charges  heavy  the  first  process  may  be  the  more  profitable. 
Often  it  is  necessary  temporarily  to  use  inferior  methods  con- 
currently with  the  most  approved  processes  because  of  the 
nature  of  the  equipment  already  purchased  or  because  of  certain 
unavoidable  market  conditions ;  but  the  classification  of  expenses 
between  the  different  processes,  if  properly  carried  out,  should 
give  information  which  would  be  useful  in  guiding  replacement 
and  improvement  policies. 

The  determination  of  the  best  method  of  remunerating  labor 
is  another  problem  of  management.  Statistical  information 
concerning  individual  performances  under  different  wage  plans 
furnishes  a  basis  for  judgment  as  to  the  method  which  gives 
the  greatest  stimulus  to  labor  under  particular  conditions,  and 
hence  is  the  most  profitable. 

On  the  basis  of  cost  statistics  the  manager  is  able  to  set  up 
standards  of  operation  for  all  departments  and  phases  of  the 
enterprise.  Such  standards  must,  of  course,  be  continually 
revised  due  to  changing  conditions.  Further,  it  is  necessary 
to  compare  such  standards  with  the  performances  of  other 
enterprises  in  the  same  field.  But  even  if  not  applicable  to 


COST  ACCOUNTING  613 

more  than  one  enterprise,  adequate  standards  as  a  goal  for 
operating  efficiency  are  of  great  assistance  to  the  individual 
manager. 

In  any  discussion  of  managerial  statistics  the  point  should  be 
emphasized  that  much  data  of  importance  to  the  manager  is  not 
accounting  or  financial  data  in  any  proper  sense  of  the  term. 
Physical  statistics  are  often  of  more  importance  to  the  manager 
than  value  statistics.  A  record  of  labor  efficiency  is  best  stated 
in  terms  of  physical  facts.  Ton-mile  and  car-mile  statistics  in 
railway  operation  are  of  value  to  the  manager  but  are  evidently 
not  accounting  data.  Further,  while  cost  data  may  be  of 
considerable  use  to  the  manager  such  facts  cannot  be  directly 
used  by  those  ultimately  in  control  in  determining  the  efficiency 
of  management  itself.  The  manager  is  not  responsible  for  general 
economic  conditions  and  hence  has  no  control  over  material 
costs  and  labor  prices.  He  is  not  responsible  for  all  accidents, 
weather  conditions,  etc.,  and  hence  should  not  always  be  criti- 
cized because  of  high  repair  and  maintenance  charges.  On  the 
other  hand  the  manager  is  supposed  to  exercise  foresight  and 
judgment  in  adjusting  the  needs  of  the  enterprise  to  market 
conditions.  Further,  any  significant  variation  in  costs  serves 
notice  on  those  finally  in  control  and  calls  for  an  explanation  on 
the  part  of  the  operating  management. 

The  treatment  of  interest  charges  in  cost  accounts  is  a  question 
which  has  attracted  a  great  deal  of  attention.  According  to  the 
view  stressed  at  various  points  in  the  preceding  chapters  interest 
is  always  a  distribution  of  net  revenue  and  is  not  an  operating 
expense.  The  point  has  been  repeatedly  emphasized  that  no 
phase  of  the  service  of  ownership  should  be  capitalized  in  any 
sense  and  appear  in  the  accounts  as  either  an  asset  or  an  expense 
charge.  The  determination  of  net  revenue  is  perhaps  the  most 
important  function  of  the  accounts,  and  this  figure  is  shown  by 
the  difference  between  accrued  revenues  and  purchased  commod- 
ities or  services  expired  in  producing  that  revenue.  Admitting, 
however,  that  the  analysis  of  interest  given  in  the  foregoing 
pages  is  correct  as  far  as  the  purposes  of  general  financial  account- 
ing are  concerned,  it  might  still  be  urged  that  interest  on  invested 
capital  should  be  treated  as  a  cost  for  cost  accounting  purposes. 

In  the  first  place  it  might  be  said  that  the  viewpoint  of  the 


6 14  PRINCIPLES  OF  ACCOUNTING 

hired  manager  is  quite  distinct  from  that  of  the  owners.  The 
interests  of  the  manager  are  not  opposed  to  the  interests  of  the 
equities,  but  are  rather  subordinate  to  them.  In  a  sense  the 
manager  must  look  upon  the  establishment  from  the  standpoint 
of  an  outsider.  Not  only  is  the  disposition  of  all  services  and 
commodities  purchased  under  his  direction,  but  the  disposal  of 
the  services  of  ownership  itself  (waiting,  risk-taking,  etc.)  rests 
in  his  hands.  Hence  the  manager  might  view  the  cost  of  pro- 
duction in  the  same  light  as  does  the  economist  who  considers 
cost  to  mean  the  total  economic  cost,  including  interest  and  profits 
at  the  margin,  necessary  for  the  production  of  a  particular 
product.  Accordingly,  in  the  comparison  of  periods  of  operation, 
different  plants  and  departments,  and  processes  of  production, 
statistics  showing  total  cost  (including  a  fair  return  on  the 
capital  invested)  per  plant  or  per  process  are  of  importance. 
Particularly  in  comparing  processes  involving  varying  proportions 
of  fixed  capital  and  direct  labor  are  such  calculations  of  utility. 

Cannot  the  manager,  however,  make  such  a  calculation  in  the 
same  way  as  would  the  owner  without  setting  up  interest  charges 
as  costs?  In  comparing  methods  is  it  not  the  one  which  yields 
the  greatest  return  on  the  total  capital  invested  which  is  the 
most  desirable?  This  seems  a  fairly  reasonable  proposition, 
and  to  make  comparisons  in  this  way  requires  no  fictitious 
expense  charges  in  the  cost  accounts.  Process  A  can  be  com- 
pared with  process  B  on  this  basis  by  simply  recognizing  all 
depreciation,  maintenance,  and  other  actual  operating  costs  in 
both  cases,  and  computing  the  cost  per  unit  of  output  for  each 
method.  Would  it  not  obscure  rather  than  clarify  the  actual 
situation  for  the  manager  if  interest  on  invested  capital  were 
charged  to  expense  in  each  case  at  some  arbitrary  rate  ? 

At  any  rate  if  any  interest  charges  are  brought  into  the  cost 
accounts  at  all  the  only  logical  procedure  is  to  consider  interest 
—  and  reasonable  profits  as  well  —  on  all  the  capital  involved 
whether  invested  in  fixed  or  working  assets  as  a  cost.  If  the 
outlay  in  question  is  a  large  one  in  which  several  equities  are 
represented,  it  will  be  necessary  to  determine  this  cost  on  the 
basis  of  the  different  rates  of  return  involved.  In  the  case  of  a 
going  concern  where  all  the  capital  furnished  is  already  amal- 
gamated in  one  fund  used  for  a  variety  of  purposes  any  such 


COST  ACCOUNTING  615 

determination  of  the  rates  involved  in  a  specific  part  of  the 
investment  is  impossible.  In  fact  the  use  of  interest  charges  in 
cost  accounts  on  anything  like  a  rational  basis  is  a  procedure 
which  faces  almost  insurmountable  practical  obstacles.  It  is 
probably  this  fact  rather  than  the  logic  of  the  case  that  is  causing 
cost  accountants  to  begin  to  recover  from  the  interest  obsession. 
Several  recent  discussions  of  the  subject  clearly  show  the 
impropriety  of  charging  to  expense  arbitrary  sums  which  will 
naturally  bear  no  very  close  relation  to  rates  actually  realized 
year  by  year  by  the  specific  concern  (which  charges  are  adjusted 
by  concurrent  fictitious  credits  to  revenue).  The  doctrine 
seems  to  have  been  due  to  a  confusion  of  commercial  concepts 
and  practice  with  certain  ideas  of  economic  theory,  and  appears 
to  be  losing  adherents. 

THE   CLASSIFICATION   AND   DISTRIBUTION   OF   EXPENSE 

The  central  problem  for  the  cost  accountant  consists  in  the 
classification  and  allocation  of  expense  charges  for  managerial 
purposes  on  an  appropriate  functional  basis  or  bases.  The 
principal  types  of  costs  mentioned  above  in  which  the  manager 
may  be  interested  may  be  summed  up  as  follows:  (i)  cost  per 
plant  or  department ;  (2)  cost  per  method  or  process  ;  (3)  cost 
per  successive  operation  or  stage  in  production ;  (4)  cost  per 
order  or  job  ;  and  (5)  cost  per  line  or  unit  of  product.  A  partic- 
ular system  of  cost  accounts  may  be  constructed  with  the  idea 
of  furnishing  several  such  types  of  information,  or  the  system 
may  be  organized  in  such  a  way  as  to  stress  simply  one  important 
line  of  analysis.  In  the  following  discussion  reference  will  be 
made  primarily  to  the  questions  that  arise  in  allocating  costs  to 
successive  production  stages  and  to  particular  lines  of  product. 

The  total  expense  of  operation  may  be  classified  into  direct  and 
indirect  charges.  For  cost  accounting  purposes  this  is  an  im- 
portant line  of  division.  All  materials  and  services  consumed 
which  can  evidently  be  assigned  to  the  production  of  a  particular 
line  of  product,  or  to  a  specific  process,  operation,  or  depart- 
ment, constitute  direct  charges.  The  wages  of  a  machine 
operative,  for  example,  are  directly  assignable  charges  provided 
workman  and  machine  are  devoted  continuously  to  a  particular 


616  PRINCIPLES  OF  ACCOUNTING 

purpose.  On  the  other  hand  all  materials  and  services  consumed 
which  cannot  be  allocated  to  definite  functions,  except  on  some 
more  or  less  arbitrary  basis,  represent  the  indirect  expense. 
The  salary  of  a  general  superintendent  is  such  a  charge.  Rela- 
tively few  types  of  expense  can  be  placed  wholly  in  either  class. 
Labor,  for  example,  in  nearly  all  cases  must  be  classified  into 
direct  and  indirect  labor;  and  the  same  may  be  said  of  raw 
material  and  many  kinds  of  supplies  and  services. 

A  further  classification  of  expense  conforms  to  the  nature  of 
the  enterprise  and  the  various  stages  of  the  productive  process. 
Thus  there  is  manufacturing  expense  and  selling  expense.  The 
nature  of  the  difficulties  arising  in  making  even  such  a  simple 
functional  division  of  expense  charges  was  discussed  in  Chapter 
VII.  The  general  and  administrative  expenses  must  either 
be  grouped  separately  or  apportioned  arbitrarily  between  the 
manufacturing  and  selling  departments. 

The  line  of  demarcation  between  direct  and  indirect  expense 
is  not  obvious  in  many  cases.  Miscellaneous  supplies  such  as 
oil,  waste,  small  parts,  etc.,  for  example,  are  usually  considered 
as  an  indirect  expense,  although  as  a  matter  of  fact  many  such 
items  enter  directly  into  specific  units  of  product  and  could  be 
allocated  to  such  product  if  the  amount  of  clerical  work  involved 
did  not  render  this  inexpedient.  Again  the  wages  of  a  particular 
workman  may  be  in  part  direct  charges  and  in  part  indirect. 
An  operative,  for  example,  may  be  transferred  from  one  task  to 
another  during  the  day.  Part  of  his  time  may  be  devoted  to 
repair  work  on  the  main  power  plant,  and  part  to  the  operation 
of  a  machine.  Careful  records  must  be  kept  in  such  cases  of 
labor  time  and  its  uses,  if  reasonable  results  are  to  be  attained  in 
dividing  labor  costs  between  direct  and  indirect  charges. 

Assuming  that  it  is  possible  to  distinguish  between  direct  and 
indirect  expense  the  problem  of  allocating  indirect  expense  to 
specific  departments,  processes,  and  lines  and  units  of  product 
arises.  The  amount  of  indirect  expense  may  be  assigned  to 
types  of  product  in  various  ways.  It  may  be  spread  over  the 
entire  output  on  some  arbitrary  basis,  or  it  first  may  be  appor- 
tioned between  phases  of  the  business,  or  it  may  be  allocated 
directly  to  some  smaller  unit  such  as  the  job  through  the  use 
of  machine  rates.  Probably  the  latter  procedure  is  the  most 


COST  ACCOUNTING  617 

adequate,  but  it  should  be  emphasized  that  whatever  method 
is  adopted  some  more  or  less  arbitrary  bases  of  distribution 
must  be  used.  Where  burden  or  indirect  expense  is  worked 
into  a  machine  rate  the  usual  procedure  is  to  divide  the  plant 
into  appropriate  production  centers  or  machine  units  and 
use  up  the  burden  in  determining  the  hourly  cost  to  operate 
each  unit.  In  making  up  these  hourly  costs  different  bases  are 
used  in  distributing  the  different  elements  of  the  indirect 
charges.  The  cost  of  light,  for  example,  may  be  distributed  as 
a  function  of  floor  space.  Cubic  space,  on  the  other  hand, 
would  seem  a  more  reasonable  basis  for  distribution  in  the  case 
of  the  cost  of  heat. 

In  some  cases  it  is  found  convenient  to  work  nearly  all  costs, 
direct  and  indirect,  into  machine  rates.  In  others,  direct 
material  and  labor  costs  are  handled  separately.  Often  some 
element  of  burden  is  found  practically  unassignable,  on  any 
rational  basis,  and  is  not  allocated  at  all.  Evidently  if  this  un- 
assignable cost  is  relatively  large  the  cost  analysis  is  admittedly 
inadequate. 

A  method  of  allocation  frequently  employed  is  the  distribution 
of  indirect  expense  in  proportion  to  the  direct.  For  example,  if 
the  direct  expense  incurred  in  producing  a  particular  unit  of 
product  is  two  per  cent  of  the  total  direct  expense  for  the  period, 
then  according  to  this  method  two  per  cent  of  the  total  indirect 
expense  of  the  same  period  would  be  charged  to  this  product. 
Similar  methods  are  the  distribution  of  overhead  on  the  basis  of  a 
single  direct  cost  such  as  that  of  labor  or  materials.  Such 
methods  are  in  most  cases  unsatisfactory.  Usually  there  is  a 
marked  divergence  between  the  percentages  of  direct  and  in- 
direct expense  involved  in  the  production  of  particular  units. 
Frequently  a  large  percentage  of  direct  expense  goes  with  a  small 
overhead  charge.  For  example,  the  skilled  workman  receiving 
$5  per  day  may  be  working  at  a  task  which  requires  for  equip- 
ment only  a  work  bench  and  hand  tools,  while  another  task 
requires  an  expensive  automatic  machine  and  the  attention  of 
an  unskilled  workman  drawing  $2  per  day.  As  far  as  solving 
the  problems  of  the  manager  is  concerned  a  distribution  of 
charges  on  any  of  these  bases  is  practically  useless. 

A  large  number  of  methods  have  been  suggested  for  distributing 


618  PRINCIPLES  OF  ACCOUNTING 

indirect  expense.1  A  description  of  these  is  beyond  the  scope 
of  the  present  discussion.  No  set  rules  are  feasible  for  all 
cases.  The  conditions  in  any  particular  case  must  be  thoroughly 
investigated  and  the  various  items  constituting  indirect  expense 
must  be  allocated  on  the  most  scientific  basis  possible. 

It  is  evident  that  the  accuracy  of  cost  analysis  depends  to  a 
large  extent  upon  the  ease  with  which  total  expense  can  be 
divided  into  direct  and  indirect  charges,  and  upon  the  pro- 
portion which  these  indirect  charges  bear  to  the  total.  Cost 
statistics  undoubtedly  are  best  adapted  to  manufacturing  enter- 
prises. In  public  utilities,  where  overhead  or  indirect  expense 
forms  about  sixty-five  per  cent  of  the  total  cost,  on  the  average, 
the  efficacy  of  cost  accounting  is  not  certain.  A  railroad,  for 
example,  uses  roadbed,  track,  and  terminals  —  a  very  large 
portion  of  its  equipment  —  for  the  production  of  a  variety  of 
services,  and  therefore  a  large  portion  of  total  expense  is  indirect, 
consisting  of  maintenance,  depreciation,  etc.  The  determination 
of  the  cost  of  a  specific  service  under  such  conditions  requires 
the  use  of  arbitraries  for  such  a  large  portion  of  the  total  charge 
as  to  make  the  result  questionable.  Nevertheless,  much  interest 
is  developing  in  cost  accounting  for  railroads,  and  it  may  be  that 
a  reasonably  accurate  system  of  costs  is  possible  even  for  such 
enterprises.  Up  to  the  present  time,  however,  the  best  results 
have  been  attained  in  other  lines  of  industry. 

A  consideration  of  almost  any  intensive  method  of  costing  will 
raise  a  question  as  to  its  feasibility  because  of  its  complex  nature 
and  probable  cost  of  adoption  and  maintenance.  Most  systems 
require  the  listing  of  data  on  the  subsidiary  records  by  large 
numbers  of  employees,  and  unless  the  necessary  cards  and  sheets 
are  very  conveniently  constructed  it  is  hard  to  get  satisfactory 
results  from  the  figures  of  scores  or  hundreds  of  operatives.  In 
view  of  these  facts  a  cost  system  is  largely  a  nuisance  unless  the 
data  finally  secured  are  founded  on  actualities  and  are  not  merely 
specious  as  is  so  often  the  case. 

The  work  of  the  cost  accountant  consists  in  a  large  measure 
in  the  construction  of  a  system  of  records  which  conforms  to  the 
nature  of  the  particular  enterprise  and  is  adapted  to  disclose  the 

1  The  Proper  Distribution  of  Expense  Burden,  by  Church,  is  an  admirable 
treatise  on  this  subject. 


COST  ACCOUNTING  619 

facts  necessary  for  the  efficient  management  of  that  enterprise. 
Special  ledgers  and  journals  are  necessary  as  well  as  subsidiary 
forms  such  as  requisitions,  production  orders,  time  reports, 
process  cards,  store  records,  summary  sheets,  etc.  It  is  in 
connection  with  the  development  of  adequate  stores  accounting 
methods  and  devices  for  controlling  and  fixing  the  responsibilities 
of  employees  that  cost  accounting  has  perhaps  had  its  greatest 
utility. 

In  conclusion  it  may  be  noted  that  although  the  cost  records 
are  usually  constructed  so  as  to  intermesh  with  the  accounts 
proper  it  is  evident  that  cost  accounting  (in  its  accepted  connota- 
tion) is  quite  distinct  from  the  problems  of  general  financial 
accounting,  and  represents  a  part  of  the  statistical  side  of  scientific 
management  and  efficiency  engineering. 


XXX 

MUNICIPAL  ACCOUNTING 

THE  discussion  thus  far  has  been  concerned  exclusively  with 
the  private  business  firm.  It  has  therefore  been  necessary  to 
emphasize  the  importance  of  the  private  equities.  The  munici- 
pal corporation  is  seldom  thought  of  as  a  business  enterprise, 
and  for  this  reason  it  is  often  urged  that  scientific  accounting 
principles  do  not  apply.  As  an  organization,  however,  a  munici- 
pality may  be  compared  to  a  business  corporation.  Both  are 
corporations,  receiving  charters  from  the  state.  They  are  both 
governed  and  managed  by  a  board  —  elected  by  the  citizens 
in  the  case  of  the  municipal  corporation  and  by  the  stockholders 
in  the  business  enterprise.  They  differ  mainly  in  the  purpose 
of  organization.  The  city  is  organized  for  the  purpose  of  render- 
ing services  to  the  citizens  without  profit  (or  for  other  reasons), 
while  the  business  corporation  is  organized  for  producing  net 
income  for  its  stockholders.  In  order  to  cast  an  intelligent  vote 
at  the  municipal  elections,  a  citizen  should  have  information 
in  regard  to  the  financial  standing  of  the  city  and  a  history  of 
the  results  of  financial  transactions  during  the  preceding  period. 
The  statements  required  for  this  purpose  are  much  the  same  as 
those  prepared  for  the  business  enterprise ;  namely,  the  balance 
sheet  and  the  income  sheet. 

Furthermore,  the  governing  board  or  the  city  manager  requires 
information  of  a  nature  similar  to  that  required  by  the  manager 
of  an  industrial  plant.  This  is  needed  in  order  that  a  rational 
judgment  may  be  made  as  to  the  efficiency  of  the  organization. 
The  recent  development  of  the  commission  manager  form  of 
government  is  a  recognition  of  the  fact  that  a  city,  after  all,  is 
much  the  same  as  a  corporation  and  should  be  managed  as 
such.  Hence  municipal  cost  accounts  are  of  importance. 

620 


MUNICIPAL  ACCOUNTING  621 

That  very  few  cities  present  financial  statements  that  are 
adequate  for  the  purposes  mentioned  is  a  well-known  fact. 
The  accounting  systems  for  cities  are  generally  of  the  primitive 
cash  book  class,  that  is,  transactions  are  recorded  only  as  cash 
is  received  or  paid  by  the  city,  and  the  only  statements  which 
are  prepared  at  the  end  of  the  year  are  those  which  show  the 
amount  of  cash  received  and  disbursed  during  the  year.  It  is 
the  purpose  of  this  chapter  to  explain  briefly  the  use  of  the 
standard  accounting  statements  for  the  municipal  enterprise. 

THE  MUNICIPAL  BALANCE  SHEET 

The  council  is  intrusted  with  the  administration  of  certain 
properties,  and  unless  a  proper  statement  of  the  condition  of 
these  properties  is  given  at  the  beginning  and  end  of  each  year, 
the  council  cannot  be  held  to  a  strict  accountability  for  its 
administration.  The  statement  which  should  be  used  for 
this  purpose  is  the  balance  sheet.  The  assets  in  this  case  would 
consist  of  all  properties  owned  by  the  city,  actual  improvements 
to  public  streets  and  parks,  all  uncollected  taxes  and  assessments, 
and  actual  cash  balances  in  the  various  funds.  The  liabilities 
would  consist  of  the  bonds  outstanding  and  the  current  liabilities 
incurred  but  not  yet  paid.  The  difference  between  the  assets 
and  the  liabilities  is  the  surplus.  This  represents  the  amount  of 
permanent  assets  which  have  already  been  paid  for.  This  item 
is  the  only  account  appearing  on  the  balance  sheet  which  is  not  a 
strictly  private  equity.  It  represents  the  collective  public 
equity  in  municipal  property.  Thus  it 'may  be  seen  that  the 
property-equity  classification  applies  to  the  municipal  accounts 
as  well  as  to  the  private  concern's  accounts. 

Balance  sheets  prepared  each  year  may  be  used  for  comparative 
purposes  and  will  give  a  clear  idea  of  the  policy  of  the  city. 
They  will  show  whether  a  city  is  paying  for  its  improvements  as 
it  goes,  or  is  accumulating  a  debt  to  pay  for  current  services. 
As  long  as  the  value  of  the  assets  exceeds  the  liabilities,  the  city 
is  paying  as  it  goes ;  but  when  the  liabilities  exceed  the  assets,  a 
debt  is  being  laid  up  against  the  future. 

It  would  be  a  relatively  simple  matter  for  most  cities  to  pre- 
pare a  balance  sheet  each  year,  although  the  first  one  would 


622  PRINCIPLES  OF  ACCOUNTING 

present  some  difficulties.  An  appraisal  should  be  made  of  all 
land  owned  by  the  city  by  a  person  competent  to  judge  of  land 
values.  This  figure  would  constitute  the  land  value  on  the 
first  balance  sheet.  As  new  land  is  acquired,  all  costs  of  acquiring 
title  should  be  debited  to  this  land  asset  account,  and  as  any 
land  is  disposed  of  by  the  city,  the  value  as  appearing  in  the 
balance  sheet  should  be  credited.  This  would  always  leave  the 
land  account  on  the  balance  sheet  at  a  figure  representing  the 
cost  of  the  land  owned.  Of  course  permanent  increment  in 
land  value  may  be  taken  into  account  in  the  same  manner  as 
was  shown  for  the  business  enterprise. 

The  buildings  and  structures  may  be  appraised  on  the  basis 
of  cost  to  reproduce  (or  original  cost  if  that  figure  is  available) 
minus  depreciation.  The  value  of  the  buildings  in  the  balance 
sheet  should  always  be  the  value  at  the  date  the  balance  sheet 
is  prepared.  This  will  insure  that  a  proper  portion  of  the  cost 
of  the  buildings  will  be  charged  as  expense  each  year.  Further- 
more, this  will  have  a  good  effect  on  the  method  of  financiering. 
Suppose  that  a  municipal  building  has  been  erected  at  a  cost  of 
$80,000  and  it  is  shown  by  the  Building  account  to  be  worth 
$40,000  at  the  end  of  the  tenth  year ;  and  that  $80,000  of  the 
bonds  are  still  outstanding  with  no  sinking  fund  to  retire  them. 
It  will  readily  be  seen  that  some  source  of  revenue  must  be  found 
to  meet  the  $80,000  due  in  ten  years.  If  the  bonds  were  to  run 
to  maturity  without  a  sinking  fund  to  retire  them,  and  if  the 
building  were  to  be  destroyed  at  that  time,  the  future  citizens 
would  be  compelled  to  pay  for  a  building  which  had  been  com- 
pletely consumed.  Situations  of  the  sort  described  often  occur 
under  present  methods. 

Public  improvements  such  as  paving  can  also  be  valued  on 
the  basis  of  cost  of  reproduction  less  accrued  depreciation  and 
the  same  can  be  said  of  all  other  permanent  property  items. 
Once  valuations  have  been  placed  upon  the  fixed  asset  items,  the 
continued  revaluations  can  be  made  at  the  end  qi  each  fiscal 
year  just  as  though  the  property  belonged  to  a  private  corpora- 
tion. Methods  of  accounting  for  depreciation  apply  with  equal 
force  to  the  assets  of  a  municipal  enterprise. 

The  balance  sheet  is  completed  by  placing  the  liabilities  in  a 
column  opposite  the  assets.  General  ledger  accounts  may  be 


MUNICIPAL  ACCOUNTING  623 

opened  for  each  asset  and  equity  item  and  subsequent  entries 
made  according  to  ordinary  commercial  accounting  principles. 
The  ease  with  which  such  a  statement  can  be  prepared  and  with 
which  subsequent  transactions  can  be  recorded  answers  the 
objection  so  frequently  urged  against  the  municipal  balance 
sheet ;  namely,  that  it  is  next  to  impossible  to  prepare  one. 

Another  objection  which  should  be  considered  seriously  is  that 
such  a  balance  sheet  is  of  no  importance  after  it  is  prepared.  It 
is  urged  that  such  a  statement  is  not  needed  to  guide  the  actions 
of  the  investor  in  municipal  properties  as  in  the  case  of  the  pri- 
vate concern,  and  that  a  simple  schedule  of  property  would  be 
sufficient  for  managerial  purposes.  These  statements  are  both 
true.  The  private  investor  in  municipal  bonds  is  not  concerned 
with  the  valuations  of  civic  assets  in  the  balance  sheet ;  he  is  con- 
cerned with  the  legality  of  the  bond  issue  and  the  ability  of  the 
city  to  assess  taxes  sufficient  to  cover  his  claim.  Admitting  all 
this,  it  may  still  be  claimed  that  the  balance  sheet  serves  a 
function.  One  of  the  principles  of  public  finance  is  that  each 
generation  should  pay  its  own  operating  expenses,  and  the  balance 
sheet  is  the  only  definite  statement  which  shows  whether  this  is 
being  accomplished  or  not.  This  fact  alone  is  sufficient  justifi- 
cation for  insisting  on  the  importance  of  such  a  statement. 

THE   MUNICIPAL  INCOME   SHEET 

If  current  operating  expenses  are  to  be  met  out  of  current 
taxes,  an  income  sheet  is  necessary.  A  budget  is  required  of  the 
city  council  at  the  beginning  of  each  year  in  which  the  estimated 
expenses  for  the  ensuing  year  are  stated  together  with  the  amount 
of  revenue  required.  On  the  basis  of  this  budget  the  taxes  are 
levied.  Expense  statements  for  previous  years  are  the  basis 
for  budget  estimates,  hence  it  is  essential  that  the  expenses 
be  correctly  stated. 

The  statement  from  which  the  budget  is  prepared  in  most 
cities  at  present  is  the  cash  statement.  It  was  shown  in  Chapter 
X  that  such  a  statement  does  not  show  actual  expenses  and  that 
in  many  cases  its  use  leads  to  entirely  erroneous  conclusions. 
This  being  the  case,  it  is  clear  that  it  should  not  be  used  for 
budget  making.  What  is  needed  is  a  statement  which  shows 


624  PRINCIPLES  OF  ACCOUNTING 

actual  expenses,  regardless  of  whether  cash  is  paid  for  the  same 
within  the  period  or  not,  and  the  revenue  accruing  in  the  same 
period  regardless  of  the  amount  of  cash  received  —  in  other 
words  an  income  sheet. 

A  cash  statement  is  of  importance  in  the  municipal  enter- 
prise. It  can  be  used  for  checking  the  stewardship  of  the  city 
treasurer.  But  this  is  the  limit  of  its  effectiveness  and  it 
should  not  be  used  as  a  substitute  for  expense  and  revenue 
accounts. 

Comparisons  of  the  expenses  of  one  city  with  those  of  another 
and  also  between  expenses  incurred  by  one  administration 
with  those  of  a  preceding  administration  in  the  same  city  are 
of  interest.  For  these  purposes  actual  expenses  are  desired, 
not  cash  disbursements.  Where  cash  statements  are  depended 
upon  for  these  purposes  it  has  often  been  the  practice  of 
certain  retiring  officials  to  make  large  purchases  immediately 
before  leaving  office  in  order  that  the  disbursements  of  the 
succeeding  year  will  be  large  and  reflect  discredit  on  the  new 
officials.  Such  practices  would  not  be  effective  were  expense 
statements  used  for  comparative  purposes.  With  a  statement 
of  expenses  to  be  prepared  each  year,  the  various  department 
heads  attempt  to  show  lower  expenses  for  the  same  service 
performed  or  greater  services  for  the  same  expenses  reported  by 
preceding  years.  This  puts  the  city's  affairs  on  a  more  business- 
like basis. 

For  the  purposes  of  direct  administrative  control  it  is  essential 
to  classify  the  expenses  of  each  department  so  that  standards  of 
operation  can  be  set  up  in  much  the  same  way  as  for  the  private 
enterprise.1  A  further  purpose  of  such  a  classification  is  to 
obtain  unit  costs  of  services  which  can  be  used  in  estimating  the 
expenses  incident  to  instituting  new  methods  of  operation. 
In  the  larger  cities  an  elaborate  system  of  cost  accounts  is 
essential  to  proper  administrative  control.  The  managing 
officer  or  even  the  departmental  head  is  confronted  with  many, 
if  not  all,  of  the  managerial  problems  mentioned  in  the  last 
chapter.  In  the  smaller  cities  a  simple  expense  classification 
will  often  be  of  sufficient  service. 

The  following  outline  suggests  some  of  the  more  important 
1  See  Chapter  XXV. 


MUNICIPAL  ACCOUNTING  625 

kinds  of  information  which  should  be  supplied  by  classified 
expense  accounts.  ,  In  a  small  city  the  items  in  the  outline 
might  be  used  as  ledger  accounts;  the  list  of  accounts  in  this 
case  would  be  complete.  In  the  larger  cities,  each  of  these  items 
would  be  subdivided  in  much  greater  detail. 


i.   Police  Department. 

(a)  Administration. 
(ft)  Patrol  Expenses. 

(c)  Traffic  Regulation. 

(d)  Enforcing  Municipal  Ordinances. 

(e)  Maintaining  Buildings  and  Equipment. 
(/)    General  Operating  Expenses. 


2.   Fire  Department. 

(a)  Administration. 

(&)  Fire  Prevention. 

(c)  Fire  Fighting  Expense. 

(d)  Maintaining  Buildings. 

(e)  General  Operating  Expenses. 

3.   Health  Department. 

(a)  Administration. 

(b)  Statistical  Expenses. 

(c)  Inspection. 

(d)  Hospital  Service. 

(e)  Sewage  Disposal. 

(/)  General  Operating  Expenses. 

The  expenses  of  each  of  the  other  administrative  departments 
would  be  subdivided  in  this  same  way.  In  the  case  of  depart- 
ments furnishing  commercial  services  such  as  the  supplying  of 
water,  electricity  or  street  railway  service,  it  is  necessary  to 
classify  both  revenue  and  expense  accounts.  It  is  usually  the 
purpose  to  charge  the  consumer  for  such  services  at  approximately 
cost.  Revenue  and  expense  accounts  should  therefore  be  classi- 
fied in  convenient  form  for  comparative  purposes.  The  follow- 
ing is  an  illustration  of  a  classification  for  a  water  department 
which  could  be  used  by  small  cities. 

2S 


626  PRINCIPLES  OF  ACCOUNTING 

\Vator  Department. 
Revenue : 
Private  service. 

(a)  Metered. 

(b)  Unmetered. 

Municipal  service. 

(a)  Fire  protection. 

(b)  Parks. 

(c)  Public  buildings,  etc. 

Miscellaneous  revenue. 

(a)  Special  work. 

(b)  Meter  rentals. 

(c)  Sundry  accounts. 

Expenses : 
General. 

(a)  Administration. 

(b)  Insurance,  etc. 

Operating. 

(a)  Operating  management. 

(b)  Collection  system. 

(c)  Distribution  system. 

Maintenance. 

(a)  Collection  system  repairs. 

(b)  Distribution  system  repairs. 

(c)  Depreciation  on  plant. 


THE   MUNICIPAL   BUDGET 

The  power  of  control  over  city  finances  which  is  retained  by  the 
citizens  is  their  right  to  approve  or  disapprove,  at  the  municipal 
elections,  of  the  council's  method  of  administration.  In  order 
that  this  right  may  be  exercised  in  an  intelligent  manner,  a 
financial  program  should  be  approved  by  the  citizens  at  the 
beginning  of  each  fiscal  year.  The  statement  to  be  supplied  by 
the  city  officials  for  this  purpose  should  contain  a  report  of  the 
financial  results  of  the  previous  year's  activities,  and  the  plans  of 
the  administration  for  the  ensuing  year,  together  with  the  costs 
and  the  contemplated  means  of  raising  the  necessary  funds. 
The  ordinary  practice  of  city  councils  is  to  publish  a  statement 


MUNICIPAL  ACCOUNTING  627 

of  receipts  and  disbursements,  together  with  an  estimate  of  the 
cash  to  be  raised  during  the  following  year  through  taxes. 
Although  the  name  budget  is  often  attached  to  such  a  statement, 
it  furnishes  little  of  the  information  needed  by  the  citizens,  nor 
has  it  proved  effective  in  placing  a  limitation  on  the  expenditures 
of  city  councils. 

The  most  important  function  of  municipal  accounts  is  the 
furnishing  of  the  material  for  the  preparation  of  the  budget. 
The  statements  which  have  been  described  are  adequate  for 
this  purpose.  The  balance  sheet  shows  the  additions  and 
improvements  during  the  year,  and  may  be  used  for  estimating 
the  cost  of  the  improvements  contemplated  for  the  ensuing  year. 
Each  department  head  should  supply  the  council  with  a  state- 
ment of  the  future  needs  of  his  department  to  aid  in  making  the 
estimates.  The  budget  should  be  published  for  the  benefit  of 
the  citizens. 

The  usual  method  employed  by  city  councils  in  apportioning 
the  income  is  to  make  appropriations  throughout  the  year  as 
the  municipal  wants  make  themselves  manifest,  until  no  funds 
are  left.  Under  this  method  the  services  which  are  not  desired 
until  late  in  the  fiscal  year  are  omitted  rather  than  the  ones  which 
are  least  important.  This  practice  would  be  prevented  by  the 
adoption  of  the  budget  each  year.  After  it  has  been  determined 
finally  what  items  should  remain  in  the  budget  in  order  to 
keep  the  tax  rate  within  the  limit,  the  budget  should  be  embodied 
in  an  ordinance  and  passed  by  the  council.  It  should  be  unlawful 
for  the  council  to  spend  more  than  the  budget  ordinance  allows 
for  any  service,  thus  insuring  that  the  program  entered  upon  at 
the  beginning  of  the  year  will  be  strictly  adhered  to. 

Although  the  council  should  not  be  allowed  to  expend  more 
than  the  budget  allows,  there  should  be  some  method  provided 
by  which  an  error  in  an  estimate  might  be  corrected  and  addi- 
tional funds  granted  for  particular  purposes.  Cases  might  arise 
in  which  an  underestimate  was  made  that  would  cause  a  loss  to 
the  city  if  the  project  were  not  completed.  The  method  of 
correcting  the  error  should  be  so  difficult,  however,  that  the 
council  would  resort  to  it  only  in  cases  of  extreme  necessity.  The 
budget  thus  adopted  should  prove  an  effective  means  of  control 
over  the  city  administration.  It  furnishes  the  information  on 


628  PRINCIPLES  OF  ACCOUNTING 

which  to  compare  one  administration  with  another,  and  presents 
a  clear  statement  of  what  is  to  be  done  with  the  amount  collected 
in  taxes. 

The  details  of  technique  in  maintaining  a  municipal  accounting 
system  on  the  plan  shown  in  this  chapter  are  somewhat  com- 
plicated. The  tax  collections  are  made  into  specific  cash  funds 
and  the  city  is  usually  prohibited  by  state  statutes  from  using 
the  cash  from  any  one  fund  for  other  purposes  than  those  listed 
as  covered  by  the  fund.  It  becomes  necessary  therefore  to  make 
a  considerable  number  of  what  maybe  called  internal  book  entries. 
Accounts  called  Budget  Allowances,  Available  Cash  Balance, 
Encumbered  Balances,  Unencumbered  Balances,  etc.  are  neces- 
sary to  record  all  possible  transactions.  It  would  be  beyond  the 
scope  of  a  general  text  in  accounting  to  explain  the  details  of  this 
technique.  It  is  sufficient  here  to  emphasize  the  importance  of 
sound  accounting  principles  in  the  municipality. 


XXXI 

RAILROAD  ACCOUNTING 

THE  controversy  concerning  the  relative  merits  of  public  and 
private  ownership  in  the  field  of  quasi-monopolistic  industry, 
and  the  present  decided  tendency  toward  the  extension  of  govern- 
mental control  in  this  direction,  have  given  rise  to  distinctive 
economic  and  accounting  problems.  These  facts,  together  with 
the  physical  peculiarities  of  public  utility  enterprises,  make  public 
utility  accounting  a  special  field  of  considerable  importance. 

In  the  field  of  public  utilities  the  railways  constitute  the  most 
important  industry.  Further,  in  this  industry  both  public 
regulation  and  accounting  practice  are  most  highly  developed. 
In  this  brief  discussion  of  public  utility  accounting,  accordingly, 
attention  will  be  directed  chiefly  to  the  railways. 

THE   I.    C.    C.    CLASSIFICATIONS 

The  Hepburn  Act  of  1906,  which  gave  to  the  Interstate 
Commerce  Commission  the  right  to  prescribe  uniform  accounting 
methods  for  transportation  agencies  engaged  in  interstate  traffic, 
recognizes  the  fact  that  public  regulation  of  industry  can  be  made 
more  effective  through  the  control  of  the  accounts.  Further- 
more, this  law  recognizes  that  intelligent  and  just  regulation  is 
possible  only  on  the  basis  of  the  information  furnished  by  an 
extensive  analysis  of  the  accounts.  Under  the  authority  of  this 
act  the  Commission  has  constructed  uniform  systems  of 
accounts  for  the  public  utilities  under  its  jurisdiction.  The 
most  important  example  of  one  of  these  systems  is  that  pre- 
scribed for  steam  railways.  This  system  is  classified  into  six 
groups  of  accounts  as  follows :  (i)  investment  in  road  and  equip- 
ment; (2)  operating  expenses;  (3)  operating  revenues;  (4) 
income;  (5)  profit  and  loss;  and  (6)  balance  sheet.  A  brief 

629 


630  PRINCIPLES  OF  ACCOUNTING 

examination  of  the  classifications  of  this  system  will  serve  to 
suggest  some  of  the  characteristics  of  railway  accounting. 

The  classification,  investment  in  road  and  equipment,  includes 
the  accounts  which  represent  the  cost  of  the  fixed  assets  used 
in  operation.  This  classification  provides  for  three  "general" 
and  seventy-seven  "primary"  accounts.  The  general  or  sum- 
mary accounts  are  :  Road ;  Equipment ;  and  General  Expendi- 
tures. Example  of  primary  accounts  under  Road  are : 
Engineering ;  Land  for  Transportation  Purposes ;  Ties ;  Rails ; 
Station  and  Office  Buildings ;  Roadway  Buildings ;  Shops 
and  Engine  Houses ;  Telegraph  and  Telephone  Lines ;  etc. 
Equipment  covers  the  following  subsidiary  accounts :  Steam 
Locomotives ;  Other  Locomotives ;  Freight-train  Cars ; 
Passenger-train  Cars ;  Floating  Equipment ;  Work  Equipment ; 
and  Miscellaneous  Equipment.  Those  under  General  Expendi- 
tures are  :  Organization  Expenses ;  General  Officers  and  Clerks ; 
Law ;  Stationery  and  Printing ;  Taxes ;  Interest  during  Con- 
struction; and  Other  Expenditures — General.  The  railroads 
are  not  restricted  to  the  use  of  the  primary  accounts  prescribed 
by  the  Commission  —  a  greater  or  less  number  may  be  used 
according  to  the  needs  of  the  particular  case,  but  no  option  is 
allowed  as  to  the  character  of  the  items  entering  these  accounts. 

Previous  to  1907  (when  the  prescribed  classifications  went  into 
effect)  it  had  been  the  practice  of  many  railroad  companies  to 
enter  in  the  property  accounts  an  amount  equal  to  the  par  value 
of  the  securities  issued,  to  avoid  showing  discounts  on  securities 
on  the  balance  sheet.  Unreasonable  construction  company 
profits  also  often  contributed  to  inflated  property  values  on  the 
first  balance  sheet.  Furthermore,  the  accounting  treatment  of 
the  property  items  after  construction  has  varied  more  or  less 
with  the  success  of  the  enterprise.  Thus  roads  making  large 
earnings  often  charged  improvements  to  expense.  Other  roads 
with  small  earnings  continued  to  inflate  property  values  by 
charging  replacements  to  capital.  Consequently  the  value  of  the 
property  as  shown  by  the  accounts  often  does  not  approximate 
actual  values  as  far  as  construction  prior  to  1907  is  concerned. 
This  situation  is  unfortunate  since  the  value  of  the  property  used 
is  a  particularly  important  matter  in  railway  accounting.  The 
problem  of  valuation  is  of  more  significance  in  the  case  of  public 


RAILROAD  ACCOUNTING  631 

utilities  than  in  competitive  industry  because  of  the  accepted 
theory  that  rates  should  yield  a  fair  return  on  the  investment. 
The  purpose  of  the  present  federal  valuation  project  is  in  part 
at  least  an  attempt  to  correct  the  figure,  investment  in  road  and 
equipment,  as  it  now  stands  upon  railroad  balance  sheets. 

It  would  seem  to  be  the  purpose  of  the  entries  in  the  accounts 
of  this  classification  to  maintain  the  balances  of  these  accounts  at 
the  actual  value  of  the  property  used  for  furnishing  transportation 
services.  In  this  respect,  however,  the  rules  of  the  Commission 
have  been  conservatively  formulated.  This  is  particularly 
noticeable  in  connection  with  the  rules  covering  the  replacement 
of  certain  kinds  of  property.  When  an  item  of  abandoned  prop- 
erty such  as  ties  is  replaced,  for  example,  the  rules  prescribe 
that  "the  excess  cost  of  metal  ties  applied  in  place  of  wooden 
ties  over  the  cost  at  current  prices  of  replacing  in  kind  the 
wooden  ties  removed  shall  be  charged  to  road  equipment  account 
No.  8,  'Ties.'"  l  In  other  words  in  a  period  of  rising  prices  the 
amount  appearing  in  the  Ties  account  may  be  less  than  the  actual 
cost  of  the  ties  in  use.  Suppose,  for  example,  that  the  current 
prices  of  wooden  ties  represent  an  advance  of  twenty  per  cent 
over  the  cost  of  the  ties  being  replaced,  and  that  the  cost  of  the 
metal  ties  used  is  still  ten  per  cent  higher.  The  application  of 
this  ruling  would  evidently  mean  that  the  accounts  would  show 
but  a  ten  per  cent  increase  in  property,  although  the  new  ties 
actually  cost  thirty  per  cent  more  than  the  property  removed. 
If  the  property  is  replaced  in  kind,  but  at  a  higher  price,  the 
property  account  would  represent  the  cost  of  the  original  item 
rather  than  of  that  now  in  use.  In  case  the  property  is  replaced 
in  kind  but  at  a  lower  price  there  would  again  be  no  adjustment 
in  the  asset  account  and  an  overstated  property  value  would  be 
shown. 

These  rules  are  evidently  not  in  agreement  with  those  explained 
in  Chapter  XXII  which  state  the  correct  procedure  for  ordinary 
replacement  accounting.  Even  if  accrued  market  changes  are 
ignored  it  would  seem  sound  practice  to  follow  actual  investment 
values  in  recording  replacements  as  in  accounting  for  new  con- 
struction ;  for  otherwise  the  company  building  a  new  extension 
in  a  year  of  high  prices  is  allowed  a  high  property  valuation 

1  Classification  of  Operating  Revenues  and  Operating  Expenses  for  1914,  p.  42. 


632  PRINCIPLES  OF  ACCOUNTING 

while  a  company  making  extensive  replacements  in  kind  in  the 
same  year  is  allowed  no  increase. 

As  stated  above  it  would  seem  especially  important  in  the  case 
of  public  utility  enterprises  that  the  accounts  should  be  as 
sensitive  as  possible  to  changes  in  the  price  level,  for  in  this  way 
changing  capital  costs  can  be  recognized  and  the  rates  allowed 
adjusted  to  meet  the  new  situation.  The  rulings  mentioned  in 
a  period  of  rising  prices  would  work  to  the  disadvantage  of  the 
investor.  In  a  period  of  falling  prices  such  regulations  are 
detrimental  to  the  interests  of  the  public.  In  either  case  the 
accounts  fail  to  represent  the  value  of  the  property  marketwise ; 
and  even  if  the  basis  for  valuation  is  to  be  the  sacrifice  of  the 
investor  the  fluctuations  in  monetary  values  must  be  accounted 
for  to  obtain  this  result,  as  was  explained  in  Chapter  XX. 

It  must  be  remembered,  however,  that  the  fact  of  price  reg- 
ulation in  itself  makes  the  market  of  less  significance.  Prices  on 
the  cost  side  are  still  competitive,  but  on  the  revenue  side  are 
more  or  less  fixed.  Such  a  situation  requires  the  recognition 
of  other  considerations  than  the  market  in  making  valuations. 
Further,  although  it  is  usually  conceded  that  American  railways 
are  not  at  present  highly  over-capitalized  as  a  rule,  it  is  recognized 
that  a  more  or  less  arbitrary  conservatism  is  necessary  to  offset 
tendencies  among  railway  managements  in  the  other  direction. 
The  question  of  valuation  in  public  utility  enterprises  will  be 
further  considered  in  the  next  section. 

The  classification,  investment  in  road  and  equipment,  includes 
only  the  accounts  with  property  used  for  transportation  services 
as  was  stated  above.  It  is  a  familiar  fact,  however,  that  many 
railway  enterprises  own  other  assets  such  as  investments  in 
subsidiary  and  other  companies,  sinking  funds,  mineral  lands, 
commercial  power  plants,  hotels,  etc.  The  accounts  with 
such  items  are  included  in  the  balance  sheet  classification. 

The  operating  expense  classification  has  the  following  general 
accounts :  Maintenance  of  Way  and  Structures ;  Maintenance 
of  Equipment ;  Traffic ;  Transportation  —  Rail  Line ;  Trans- 
portation —  Water  Line ;  Miscellaneous  Operations ;  General ; 
Transportation  for  Investment  —  Credit.  These  accounts  are 
subdivided  into  two  hundred  and  ten  primary  accounts.  Under 
the  head  of  maintenance  of  way  and  structures  there  are  seventy- 


RAILROAD  ACCOUNTING  633 

nine  primary  accounts.  Examples  of  these  accounts  are : 
Superintendence ;  Roadway  Maintenance ;  Roadway  Deprecia- 
tion ;  Bridges,  Trestles,  and  Culverts ;  Ties ;  Ties  —  Deprecia- 
tion; etc.  There  is  a  maintenance  or  repair  account  for  each 
important  type  of  property,  and  usually  an  accompanying  de- 
preciation account.  In  many  cases  under  maintenance  of 
equipment  three  expense  accounts  are  provided  in  connection 
with  an  important  type  of  property,  for  example  :  Freight-train 
Cars  —  Repairs ;  Freight-train  Cars  —  Depreciation ;  and 
Freight-train  Cars — Retirements.  The  last  named  account  is 
charged  with  the  amounts  necessary  to  adjust  the  difference 
between  the  book  value  (less  scrap  value)  of  the  property  units 
retired  from  service  and  the  amount  of  accrued  depreciation  in 
the  reserve  account  applicable  to  the  units  retired. 

The  general  account  Traffic  covers  such  primary  accounts  as 
Superintendence,  Advertising,  Traffic  Associations,  Industrial  and 
Immigration  Bureaus,  Insurance,  etc.  Under  Transportation  — 
Rail  Line  there  are  fifty  primary  accounts.  These  accounts  in- 
clude under  the  appropriate  heads  the  charges  for  wages  and 
salaries,  supplies,  etc.,  in  connection  with  actual  operation. 
The  expenses  of  "miscellaneous  operations"  include  the  cost  of 
dining  and  buffet  service,  of  operating  hotels,  elevators,  stock- 
yards, etc.  " General  Expenses"  covers  administrative  salaries, 
legal  and  valuation  expenses,  .general  insurance,  supplies,  and 
similar  items.  The  last  general  account  mentioned,  Trans- 
portation for  Investment  —  Credit,  is  not  really  an  expense 
account  at  all  but  is  an  adjustment  or  clearing  account  which 
is  credited  with  "fair  allowances  representing  the  expense  to 
the  carrier  of  transporting,  on  transportation  trains,  men  en- 
gaged in  and  material  for  construction."  The  amounts  so 
credited  are  concurrently  charged  to  the  appropriate  property 
accounts. 

In  this  classification  the  line  between  expense  and  capital  is 
very  carefully  drawn,  but  it  is  evident  from  the  above  discussion 
of  the  treatment  of  replacements  that  the  rules  of  the  Commission 
do  not  apportion  charges  between  capital  and  revenue  in  strict 
harmony  with  accounting  theory.  Thus  when  rails  are  replaced 
with  more  valuable  types  operating  expense  is  charged  with 
the  cost  of  replacing  the  old  rails  in  kind  rather  than  with  the 


634  PRINCIPLES  OF  ACCOUNTING 

value  of  the  abandoned  units  as  represented  in  the  property 
account. 

The  operating  expense  classification  is  constructed  primarily 
to  meet  the  needs  of  the  operating  manager,  and  to  fix  the  respon- 
sibilities of  employees.  The  general  purpose  of  this  classification 
is  to  exhibit  the  cost  of  rendering  the  service  of  transportation. 
It  is  noticeable,  however,  that  the  primary  accounts  used  conform 
to  the  important  classes  of  commodities  and  services  purchased 
and  consumed,  and  to  the  important  types  of  equipment  and 
other  properties  in  use,  and  that  little  attempt  has  been  made 
to  classify  expenses  on  an  elaborate  functional  basis.  This 
division  of  accounts,  for  example,  does  not  even  present  the  cost 
of  passenger  traffic  as  distinct  from  the  cost  of  freight  traffic ; 
and  there  is  clearly  little  attempt  in  this  classification  to 
construct  the  accounts  so  as  to  reveal  the  cost  of  carrying  a 
particular  kind  of  freight.  As  was  explained  in  Chapter 
XXIX  cost  accounting  for  railway  enterprises  is  of  very 
doubtful  efficacy.  The  indirect  expense  —  the  depreciation 
and  maintenance  of  road  and  equipment  used  for  various  pur- 
poses, for  example  —  is  so  large  a  fraction  of  the  total  expense 
as  to  make  any  apportionment  of  charges  merely  a  specious 
division. 

In  the  matter  of  depreciation  charges  considerable  leeway  is 
allowed  the  railroad  companies.  No  set  rule  or  rules  for  measur- 
ing depreciation  are  prescribed.  The  carrier  itself  is  allowed  to 
estimate  the  annual  depreciation  charge,  but  is  required  to 
charge  one-twelfth  of  this  estimated  amount  to  the  operating 
expense  of  each  month.  In  case  the  amount  of  abandoned 
property  is  far  in  excess  of  the  reserve  for  depreciation  for  the 
type  of  property  involved,  the  company  may,  upon  specific 
authority  from  the  Commission,  carry  the  item  on  the  balance 
sheet  as  a  deferred  expense  to  be  distributed  in  the  operating 
expenses  of  succeeding  periods.  The  Commission  may  also 
grant  the  company  permission,  under  the  rulings,  to  charge  an 
unusual  loss  item  to  Profit  and  Loss.  In  view  of  what  was  said 
about  the  treatment  of  deferred  debits  in  Chapter  X  it  would 
seem  more  proper  to  always  make  these  adjustments  through  a 
surplus  or  profit  and  loss  account.  According  to  the  theory, 
however,  that  the  railway  investor  is  entitled  to  revenues 


RAILROAD  ACCOUNTING  635 

sufficient  to  cover  such  losses  the  carrying  of  abandonments  as 
deferred  assets  may  be  justified.1 

The  operating  revenue  classification  is  divided  into  four  general 
accounts  as  follows  :  Transportation  —  Rail  Line ;  Trans- 
portation —  Water  Line ;  Incidental ;  and  Joint  Facility.  The 
primary  accounts  are  thirty-nine  in  number.  Examples  of 
these  accounts  are :  Freight ;  Passenger ;  Excess  Baggage ; 
Mail ;  Express ;  Switching ;  Special  Service ;  Dining  and 
Buffet ;  Parcel  Room ;  Demurrage ;  Telegraph  and  Telephone ; 
etc.  The  Joint  Facility  account  is  used  to  record  adjustments  of 
revenues  between  companies  in  connection  with  the  operation  of 
joint  tracks,  yards,  terminals,  etc.  The  fact  that  railway  opera- 
tions in  the  United  States  are  in  many  respects  bound  into  a 
single  system  is  illustrated  by  these  special  revenue  accounts. 
Standardized  equipment  and  through  traffic  necessitate  joint 
property  and  joint  operating  records ;  and  the  work  of  the 
railway  accountant  is  naturally  considerably  modified  by  these 
inter-company  relations. 

The  revenue  classification  is  not  as  elaborately  developed  as  is 
that  of  operating  expenses.  It  might  be  considerably  expanded 
and  better  serve  the  needs  of  the  traffic  officials.  The  con- 
struction of  a  system  of  revenue  accounts  on  a  functional  basis 
is  not  a  very  difficult  matter  as  was  explained  in  an  earlier  chapter. 

In  the  rulings  covering  the  revenue  classification  the  importance 
of  recognizing  accruals  is  emphasized.  This  is  noteworthy  in 
view  of  the  fact  that  railroad  revenues  are  so  largely  on  a  cash 
basis.  It  is  recognized  that  even  in  such  a  case  the  record  of 
cash  transactions  is  not  a  satisfactory  guide  in  accounting  for 
revenues. 

The  classification  of  income  accounts  prescribed  for  railways 
corresponds  roughly  to  the  net  revenue  section  of  the  general 
income  sheet  discussed  in  previous  chapters.  There  are  some 
noticeable  differences  between  the  two,  however.  The  railway 
income  accounts  are  not  confined  to  net  items.  The  total  of 
operating  revenues  is  shown  in  a  special  account  in  this  classifi- 
cation as  is  also  the  total  of  operating  expenses.  Special  accounts 
are  provided  for  non-operating  income  such  as  hire  of  freight 

1  For  a  further  discussion  of  the  treatment  of  abandonments  and  other  phases  of 
railway  property  accounting  see  Adams,  American  Railway  Accounts. 


636  PRINCIPLES  OF  ACCOUNTING 

cars,  rent  from  locomotives,  income  from  lease  of  road,  dividend 
income,  income  from  funded  securities,  etc.  Accounts  are  pro- 
vided for  the  corresponding  deductions  from  income  including 
taxes.  The  inclusion  of  rent  items  as  debits  and  credits  to  income 
accounts  is  not  in  agreement  with  the  construction  of  the  net 
revenue  classification  as  it  has  been  outlined  in  preceding 
chapters.  Rent  or  hire  as  ordinarily  understood  is  a  gross  item, 
and  accordingly  constitutes  either  expense  or  revenue  as  the 
case  may  be.  According  to  the  rulings  of  the  Commission, 
however,  the  rent  accounts  included  in  this  classification  shall 
be  charged  or  credited  only  with  that  portion  of  the  payment  or 
receipt  which  is  net  income.  The  balance  in  each  case  is  to  be 
apportioned  between  depreciation  and  maintenance  charges  in 
the  case  of  a  payment,  and  is  to  be  credited  to  these  expense 
accounts  in  the  case  of  a  rent  receipt.  Such  a  division  of  rent 
would  be  a  matter  of  little  significance  in  ordinary  commercial 
accounting  for  evidently  any  sale  of  a  commodity  or  service 
contains  an  item  of  net  income ;  but  in  railroad  accounting  it  is 
particularly  important  that  the  actual  expense  of  operation  be 
revealed  for  rate-making  purposes,  and  hence  such  a  practice 
may  be  justified  in  this  case. 

The  profit  and  loss  classification  covers  essentially  the  accounts 
which  show  surplus  adjustments.  Special  accounts  are  provided 
for  unusual  gains  such  as  donations,  for  unusual  losses,  dividend 
appropriations,  surplus  appropriations,  etc.  One  questionable 
procedure  at  this  point  may  be  noted.  The  railroads  are 
allowed  to  "charge  to  profit  and  loss  account  No.  617,  'debt 
discount  extinguished  through  surplus, '  all  or  any  portion  of  the 
discount  and  expense  on  funded  debt  remaining  at  any  time  un- 
extinguished."  This  procedure  is  inconsistent  with  the  theory 
that  the  income  sheet  should  exactly  represent  the  fiscal  period. 
If  discount  on  funded  debt  is  not  accumulated  through  the  annual 
interest  charges,  net  proprietary  income  will  not  be  correctly 
stated  each  year. 

The  prescribed  arrangement  of  the  income  and  profit  and 
loss  items  in  the  railway  income  sheet  is  shown  in  the  illustration 
given  in  Appendix  C. 

The  balance  sheet  classification  includes  the  regular  property 
and  equity  accounts.  Among  the  property  accounts  are  Invest- 


RAILROAD  ACCOUNTING  637 

ment  in  Road  and  Equipment  and  miscellaneous  property 
accounts  such  as  Improvements  on  Leased  Railway  Property, 
Sinking  Funds,  Cash,  Investments  in  Affiliated  Companies, 
Loans  and  Bills  Receivable,  Rents  Receivable,  etc.  The  equity 
accounts  cover  the  stocks  and  bonds  outstanding,  the  appro- 
priated surplus  accounts,  the  profit  and  loss  balance,  current 
and  deferred  liabilities,  valuation  reserves,  etc.  A  peculiar 
account,  Grants  in  Aid  of  Construction,  is  used  to  cover  the 
donations  made  by  states,  municipalities,  and  other  public 
corporations  applied  to  the  construction  or  acquisition  of  prop- 
erty the  cost  of  which  is  chargeable  to  investment  in  road  and 
equipment. 

The  prescribed  form  of  the  railway  balance  sheet  is  shown  in 
Appendix  C.  The  asset  side  is  divided  into  four  main  groups  of 
items :  investments ;  current  assets ;  deferred  assets ;  and  un- 
adjusted debits.  As  in  most  balance  sheets  valuation  items  are 
not  carefully  segregated.  Items  of  discount  and  abandoned 
property  appearing  under  unadjusted  debits  are  virtually  deduc- 
tions from  proprietorship.  Rents  and  insurance  premiums  paid 
in  advance,  on  the  other  hand,  are  clearly  deferred  assets. 
Similarly  on  the  liability  side  a  current  li ability  such  as  taxes 
accrued  and  a  capital  liability  such  as  premium  on  funded  debt 
are  included  with  valuation  reserves  for  depreciation  under  the 
head  of  unadjusted  credits. 

It  is  noticeable  that  two  columns  are  provided  for  each  side 
of  this  balance  sheet.  One  purpose  of  the  "short"  column  is  to 
show  contingent  items  such  as  the  guaranteed  securities  of  other 
companies  which  are  not  included  in  the  final  totals.  Treasury 
stocks  and  bonds  are  also  shown  in  this  way.  Only  the  actual 
amount  outstanding  is  shown  in  the  "long"  column  in  each 
case.  It  might  be  advisable  to  show  the  depreciation  reserves 
also  on  the  asset  side  in  order  to  indicate  their  nature  as  property 
deductions.  A  point  of  interest  in  connection  with  the  liability 
accounts  is  the  distinction  made  between  matured  obligations 
unpaid  and  unmatured  obligations  accrued.  In  determining  the 
immediate  financial  condition  of  a  company  it  is  evident  that 
this  is  a  matter  of  some  importance. 


638  PRINCIPLES  OF  ACCOUNTING 

RATE   REGULATION  AND  ACCOUNTING 

When  public  control  of  industrial  enterprises  extends  as  far 
as  the  direct  regulation  of  prices  the  importance  of  sound  account- 
ing analysis  for  such  cases  is  in  some  respects  greatly  emphasized. 
In  industries  where  prices  are  fixed  by  competition  the  public 
has  comparatively  little  immediate  interest  in  enforcing  correct 
accounting  practice.  Competition  is  confidently  expected  to  set 
a  proper  level  of  prices  regardless  of  how  the  accounts  are  kept. 
In  such  cases  it  is  the  present  or  prospective  owners  and  the 
circle  of  business  men  connected  with  the  enterprise  in  financial 
or  industrial  relationships  whose  interests  are  served  by  sound 
accounting.1  The  enterprise  which  is  proceeding  on  the  basis  of 
extensive  statistical  information  in  regard  to  the  property  and 
equity  facts  which  represent  its  financial  status  is,  of  course, 
better  able  to  survive  the  rigors  of  business  competition  than  an 
enterprise  which  operates  more  or  less  blindly.  But  overstate- 
ment or  understatement  of  property  or  expense,  and  consequent 
inaccurate  income  and  balance  sheets,  cannot  affect  prices  to 
the  consumer  (in  any  immediate  or  direct  sense)  where  compe- 
tition fixes  these  prices.  In  the  case  of  public  utilities,  however, 
the  state  undertakes  to  control  rates,  and  —  as  was  suggested 
above  —  reasonable  rate  regulation  is  impossible  without  proper 
accounting  and  equitable  valuations. 

It  is  urged  that  the  public  utility  investor  is  entitled  to  a 
"reasonable  return  on  a  fair  value"  of  the  property.  Just  what 
this  well-worn  phrase  means  is  a  matter  of  some  dispute.  Is  the 
"fair  value"  cost,  cost  less  depreciation  due  to  physical  causes, 
or  present  value  as  determined  by  both  operating  and  market 
conditions  ?  And  how  is  the  reasonable  return  to  be  determined  ? 
It  has  been  urged  throughout  this  book  that  the  accounts  should 
register  current  property  values  as  far  as  this  is  possible  or  prac- 
ticable. It  has  been  explained  that  depreciation  is  a  matter  of 
value  decline  and  does  not  depend  entirely  upon  physical  causes. 
Further,  it  has  been  shown  that  unless  value  changes  in  both 
directions  are  made  matters  of  accounting  record  the  accounts 

1  Public  interest  is,  of  course,  advanced  by  an  efficient  utilization  of  the  economic 
resources  of  the  community.  To  the  extent  that  accounting  makes  possible  effi- 
ciency in  production,  accordingly,  its  function  is  social  as  well  as  private. 


RAILROAD  ACCOUNTING  639 

do  not  show  either  the  capital  cost  of  production  or  the  real 
sacrifice  of  the  investor.  But  the  rulings  of  the  Interstate  Com- 
merce Commission,  as  was  explained  above,  emphasize  original 
cost  as  the  proper  basis  for  the  valuation  of  public  utility  prop- 
erties. It  has  been  argued  that  this  is  not  the  most  rational 
viewpoint  as  applied  to  general  competitive  industry.  The  ques- 
tion now  arises  as  to  whether  original  cost  is  the  proper  basis 
for  determining  property  values  in  the  case  of  public  utilities. 

One  of  the  chief  arguments  in  favor  of  maintaining  original 
cost  in  the  accounts  is  based  on  the  contention  that  this  figure 
represents  the  sacrifice  of  the  investor.  As  was  explained  in 
Chapter  XX  this  would  be  true  only  in  a  regime  of  static  prices. 
In  order  to  follow  actual  original  investment  it  would  be  neces- 
sary to  account  for  monetary  fluctuation.  In  so  far  as  changes 
in  the  prices  of  the  commodities  and  services  required  in  pro- 
ducing transportation  services  conform  to  general  price  move- 
ments it  would  seem  that  current  prices  should  be  brought  on 
the  books  as  far  as  possible  if  sacrifice  is  to  be  the  accepted  basis 
for  valuation.  In  the  case  of  competitive  industry,  however, 
it  is  not  original  investment  which  represents  the  significant 
figure,  for  such  a  basis  for  valuation  assumes  that  the  speculative 
opportunities  and  accidents  of  the  actual  business  situation  are 
eliminated.  Has  original  investment  greater  significance  in  the 
case  of  public  utilities? 

To  answer  this  question  it  is  necessary  to  consider  the  attitude 
of  the  rate-making  authorities.  It  has  been  the  tendency  of 
courts  and  commissions  to  restrict  the  rate  of  net  income  allowed 
the  public  utilities  as  compared  with  normal  returns  in  other 
lines.  This  is  not  necessarily  unfair  discrimination  against  the 
utility  investor  as  a  "reasonable  return"  on  a  railway  property 
need  not  be  the  same  as  in  other  lines.  If  the  speculative  risks 
were  removed,  due  to  governmental  control,1  such  properties 
would  normally  yield  a  lower  rate  than  competitive  industry. 
Thus  far,  however,  the  policies  of  the  commissions  and  the 
attitude  of  the  courts  have  been  somewhat  in  the  direction  of 
infringing  upon  the  rights  of  the  investor.  Insistence  upon 
original  cost  as  a  basis  for  fair  value  has  worked  to  the  dis- 

1  In  taking  over  the  railroads  during  the  present  war  crisis  it  is  interesting 
to  note  that  the  government  has  promised  the  owners  an  adequate  return. 


640  PRINCIPLES  OF  ACCOUNTING 

advantage  of  the  investor  in  this  period  of  rising  prices,  and  this 
disadvantage  has  not  been  compensated  for  by  the  elimination 
of  the  possibility  of  loss.  To  offset  this  disadvantage  intangibles 
based  on  interest  charges  during  construction,  pioneering  losses 
and  other  elements  have  in  some  cases  been  allowed. 

This  situation  appears  to  be  unreasonable.  It  would  seem 
to  be  a  more  equitable  procedure  to  take  the  standpoint  of 
present  value  and  allow  a  return  on  this  value  which  would  not 
put  the  investor  in  public  utilities  at  a  disadvantage  as  compared 
with  the  investor  in  competitive  enterprises  involving  the  same 
burdens  of  ownership.  The  other  equitable  alternative  would  be 
to  guarantee  a  fair  return  to  all  public  utility  enterprises.  This 
would  seem  out  of  the  question,  however,  without  actual  gov- 
ernment ownership  or  a  very  complete  control ;  for  if  rates 
were  high  enough  to  yield  a  fair  return  to  all  enterprises  the 
public  might  be  paying  for  gross  inefficiency  and  poor  business 
judgment  in  some  cases. 

The  merely  nominal  significance  of  original  cost  in  certain 
cases  is  emphasized  by  the  fact  of  depreciation.  Allowance  for 
depreciation  must  of  course  be  made  in  determining  a  fair  prop- 
erty value  for  rate-making  purposes.  The  public  should  not  be 
required  to  pay  a  rate  on  capital  returned  to  the  investor.  It 
would  therefore  seem  to  be  of  particular  importance  that  depre- 
ciation be  carefully  recorded  in  the  accounts  of  public  utility 
enterprises.  The  use  of  the  replacement  policy  of  accounting 
for  depreciation  tends  to  obscure  the  situation  here.  In  a  rail- 
road enterprise  it  is  of  course  impossible  to  keep  all  the  items  of 
property  in  the  original  condition.  Every  item  is  gradually 
becoming  worthless  from  the  time  it  is  first  put  into  service  until 
retirement.  The  property  as  a  whole,  accordingly,  may  not  be 
at  one  hundred  per  cent  value  condition  although  kept  at  a 
high  point  of  efficiency  by  repairs  and  renewals.  If  the  repairs 
and  replacement  policy  of  charging  depreciation  is  followed,  the 
books  may  show  a  property  value  equal  to  one  hundred  per  cent 
of  the  investment  although  the  present  value  is  but  ninety  per 
cent  of  cost  new.  A  rate  based  on  the  book  value  in  such  a  case 
would  seem  to  be  illegitimate,  particularly  if  it  means  that  ten 
per  cent  of  the  investment  has  been  returned  to  the  stockholders 
as  profits. 


RAILROAD  ACCOUNTING  641 

If  reasonable  allowance  is  made  for  accrued  depreciation, 
however,  the  real  situation  is  more  clearly  presented.  When  a 
depreciation  fund  is  maintained  the  difference  between  the 
original  cost  and  the  depreciated  value  is  in  this  fund.  It  has 
not  been  returned  to  the  stockholders,  but  is  earning  a  rate  of 
return  independent  of  regular  operation.  When  the  fund  is 
invested  in  additions  to  the  property  the  depreciation  on  all 
the  property  in  use  deducted  from  the  original  cost  of  such 
property  will  leave  as  a  result  the  actual  investment.  Or,  if 
the  amount  of  depreciation  is  returned  to  the  stockholders,  the 
allowance  for  depreciation  is  nevertheless  made  in  the  accounts 
and  the  accounts  show  the  actual  present  investment.  Ignoring 
possible  value  changes  in  the  other  direction  there  can  be  no 
controversy,  when  this  policy  of  depreciation  accounting  is 
properly  carried  out,  regarding  the  propriety  of  deducting  depre- 
ciation to  obtain  fair  value. 

It  has  been  attempted  in  this  brief  statement  only  to  suggest 
some  of  the  important  questions  that  arise  in  public  utility 
valuation  and  rate  making.  In  conclusion  the  statement  made 
in  Chapter  XXIV  in  connection  with  the  discussion  of  going  value 
should  be  reiterated.  As  long  as  the  situation  remains  in  the 
present  state  of  uncertainty  many  questions  of  valuation  must  be 
left  to  the  regulating  authorities  and  need  not  affect  the  account- 
ing analysis.  Accounting  which  conforms,  however,  to  the 
natural  economic  principles  operating  in  the  competitive  situation 
can  hardly  be  said  to  be  improper  for  any  case. 


2T 


XXXII 

AUDITING 

IN  a  broad  sense  any  examination  of  the  financial  records  of 
a  business  enterprise  constitutes  an  audit.  The  work  of  the 
professional  accountant  consists  largely  in  auditing  and  in  the 
construction  of  systems  of  accounts  and  underlying  records 
suitable  to  the  needs  of  particular  industries  and  enterprises. 
A  brief  consideration  of  the  auditing  side  of  this  broad  practical 
field  will  be  given  in  this  chapter. 

THE  PURPOSES   OF  AUDITS 

An  audit  may  be  conducted  for  the  general  purpose  of  test- 
ing the  clerical  accuracy  of  the  bookkeeper's  work  and  the  ac- 
counting analysis  upon  which  it  is  based ;  or  it  may  be  under- 
taken for  some  more  specific  end,  such  as  the  determination  of 
financial  condition,  the  detection  of  fraud,  the  determination  of 
rights  at  dissolution,  etc. 

A  large  number  of  corporate  managements  feel  obliged  to  have 
their  records  audited  regularly  to  give  authenticity  to  the 
statements  issued  to  the  stockholders  and  public.  The  annual 
report  in  such  a  case  has  a  certificate  from  the  auditing  ac- 
countants appended,  declaring  the  condition  of  the  company 
to  be  as  represented.  Too  often  in  the  past  such  audits  have 
been  only  perfunctory  and  hence  have  had  little  or  no  real 
value.  As  the  accounting  profession  becomes  more  highly 
organized,  however,  it  is  coming  to  be  recognized  that  a  certifi- 
cate of  audit  from  a  reputable  accounting  firm  carries  consider- 
able weight  with  the  stockholders  and  others  interested. 

A  company  may  have  its  books  audited  in  order  to  present 
a  verified  statement  to  actual  or  prospective  creditors  as  to 

642 


AUDITING  643 

solvency  conditions.  In  making  loans  banks  often  require  such 
certified  statements.  In  the  case  of  single-proprietorships  and 
partnerships,  where  the  books  are  often  very  improperly  kept, 
the  owners  find  it  necessary  to  call  in  the  professional  auditor 
at  intervals  to  prepare  statements  of  income  and  financial 
condition.  Further,  the  auditor,  or  cost  expert,  is  often  called 
upon  to  determine  costs  and  furnish  information  concerning 
specific  problems  of  management. 

Frequently  an  audit,  or  investigation,  will  be  initiated  by  a 
group  of  stockholders  or  other  interested  parties  if  for  any  reason 
it  is  suspected  that  the  books  are  improperly  kept,  or  if  the  state- 
ments presented  by  the  company  in  its  reports  do  not  show 
sufficient  information  on  some  particular  point.  A  dispute 
between  the  minority  and  majority  stockholders  of  a  railroad 
company  furnishes  an  illustration  of  an  audit  conducted  in  the 
interest  of  a  particular  group  of  investors.  In  this  case  the 
majority  stockholders  were  represented  by  a  holding  company. 
The  holding  company  wished  to  purchase  the  equity  of  the 
minority  stockholders  in  the  subsidiary  line.  The  question 
arose  as  to  what  should  be  the  purchase  price  of  this  stock.  An 
extensive  examination  of  the  records  in  this  case  revealed  the 
fact  that  the  actual  value  of  the  stock  was  considerably  above 
the  current  market  price  per  share.  The  holding  company, 
owning  a  majority  interest,  had  had  active  financial  control  of 
the  enterprise  and  it  had  been  the  policy  of  the  parent  company 
to  use  the  subsidiary  line  as  a  feeder  to  its  main  properties. 
The  income  on  the  investment  in  the  smaller  road  had  been 
obtained  primarily  from  the  added  traffic  derived  from  the  con- 
trol of  this  road,  rather  than  from  dividends  on  the  stock  held. 
Consequently  the  controlling  interest  had  had  little  object  in 
declaring  large  dividends.  It  was  shown  further  that  it  had 
been  the  policy  of  the  management  to  understate  net  revenue  by 
charging  improvements  to  expense,  and  thereby  creating  secret 
reserves.  These  facts  had  resulted  in  building  up  the  proprietary 
equity  in  the  business  to  an  extent  not  reflected  on  the  stock 
market  or  in  the  accounts.  The  investigation  resulted  in  the 
sale  of  the  minority  stock  on  a  more  equitable  basis. 

The  following  case  presents  a  somewhat  similar  situation. 
In  the  case  of  a  certain  corporation  an  agreement  was  entered 


644  PRINCIPLES  OF  ACCOUNTING 

into  between  the  preferred  and  common  stockholders  at  the  time 
of  organization  which  provided  that  the  preferred  stock  should 
have  exclusive  voting  privileges  until  five  consecutive  annual 
dividends  of  seven  per  cent  were  paid  on  that  stock.  During 
ten  years,  although  there  had  been  a  favorable  showing  of  gross 
revenue  throughout  this  period,  net  revenue  was  not  sufficient 
to  pay  the  dividends  required  for  the  consummation  of  the  above 
agreement.  A  group  of  common  stockholders  instituted  an 
investigation  of  the  company's  accounting  methods  to  determine 
whether  or  not  net  revenue  had  been  correctly  stated.  In  this 
case  also  it  was  found  that  net  revenue  had  been  understated 
through  errors  in  accounting  analysis.  Sinking  fund  install- 
ments, and  many  items  of  new  construction  in  addition  to  actual 
depreciation,  had  been  charged  to  the  expense  accounts.  Had 
these  amounts  been  properly  charged  net  revenue  would  have 
been  sufficient  to  allow  the  payment  of  seven  per  cent  on  the 
preferred  stock  each  year.  Thus  the  common  stockholders  had 
been  prevented,  through  errors  in  accounting  judgment,  from 
exercising  their  rightful  control  of  the  business  for  a  period  of 
five  years. 

Outside  interests  often  desire  to  have  the  financial  records  of  a 
business  examined.  The  purposes  of  such  examinations  are 
varied,  and  many  peculiar  problems  present  themselves  in 
specific  cases.  The  following  case  furnishes  an  illustration. 
In  a  certain  town  both  a  municipal  enterprise  and  a  private  con- 
cern were  furnishing  electric  light  and  power.  The  municipal 
company  (which  was  also  the  city  water  company)  was  cutting 
prices  for  electricity  far  below  cost  to  the  private  concern. 
The  latter  company  had  reason  to  believe  that  the  municipal 
enterprise  was  not  allocating  costs  properly  between  the  water 
and  light  departments.  An  audit  of  the  municipal  company's 
books  which  was  finally  instituted  discovered  that  the  water 
rates  were  covering  a  considerable  portion  of  the  expense  properly 
assignable  to  the  production  of  light. 

The  state  and  federal  governments  are  responsible  for  a  large 
number  of  examinations.  The  books  of  banking  institutions  are 
regularly  examined  by  government  auditors.  Such  audits  are 
undertaken  primarily  to  prevent  embezzlements  and  other 
improper  use  of  the  depositors'  funds.  Frequent  failures  due  to 


AUDITING  645 

peculations  covering  a  period  of  years  show  that  these  examina- 
tions are  not  always  sufficiently  thorough;  but  there  can  be 
little  doubt  that  such  regulation  in  general  has  a  salutary  effect 
upon  banking  practice. 

In  the  case  of  the  railroads  the  Interstate  Commerce  Com- 
mission has  the  power  to  examine  the  books  of  an  enterprise 
under  its  jurisdiction  at  any  time.  In  many  states  the  public 
utilities  commissions  have  similar  powers.  The  following  case 
illustrates  a  type  of  problem  which  frequently  presents  itself  to 
the  state  commissions.  A  power  company  petitioned  a  certain 
commission  for  permission  to  issue  $10,000,000  in  capital  stock. 
An  appraisal  showed  the  value  of  the  physical  property  to 
be  $7,000,000  but  the  company  argued  that  a  going  value  of 
$3,000,000  existed  because  of  early  losses.  Assuming  the  legiti- 
macy of  such  an  intangible,  the  task  for  the  auditors  in  this  case 
would  be  the  examination  of  the  financial  records  covering  the 
period  in  question  in  order  to  determine  the  amount  of  net 
revenue  or  loss  for  each  year. 

The  recent  federal  tax  legislation  has  forced  a  recognition  of  the 
importance  of  proper  accounting.  Many  firms  and  corporations 
are  requiring  the  assistance  of  professional  accountants  in 
preparing  income  and  balance  sheets  to  be  used  as  a  basis  for 
reporting  tax  returns.  Tax  laws,  moreover,  do  not  always 
conform  to  consistent  accounting  principles,  and  some  adjust- 
ments may  be  necessary  even  if  the  accounts  are  kept  on  an 
entirely  rational  basis  for  private  purposes.  The  charging  of 
allowances  for  proprietors'  salaries  to  expense,  referred  to  in 
Chapter  XI,  is  an  illustration  of  such  an  adjustment. 

Audits  are  often  necessary  at  times  of  organization,  reor- 
ganization, merger,  dissolution,  etc.  In  the  case  of  insolvency 
experts  are  usually  called  in  to  prepare  schedules  of  assets  and 
liabilities  and  a  showing  of  the  proprietary  balance  and  its 
distribution  if  there  is  any  such  balance.  Also  in  connection 
with  the  administration  of  estates  and  similar  matters  certified 
statements  from  auditors  are  often  required. 

It  should  be  evident  from  this  brief  statement  that  the  field 
of  auditing  is  a  broad  one  and  might  be  said  to  include  the  ana- 
lytical or  interpretative  side  of  professional  accountancy. 


646  PRINCIPLES  OF  ACCOUNTING 

THE  ESSENTIALS   OF  AUDITING 

The  illustrative  cases  mentioned  above  emphasize  the  fact 
that  although  one  of  the  purposes  of  the  general  audit  is  the 
verification  of  the  clerical  work  it  is  a  much  more  important 
function  of  the  auditor  to  discover  whether  or  not  sound  ac- 
counting principles  have  been  observed.  The  checking  of  post- 
ings and  column  totals  is  not  a  particularly  illuminating  process. 
In  fact,  column  totals  may  check,  debits  may  equal  credits,  and 
still  flagrant  violations  of  accounting  principles  may  exist. 
If  repair  outlays,  for  example,  are  charged  to  property  instead  of 
to  expense,  the  accuracy  of  the  clerical  work  may  be  unquestioned, 
but  nevertheless  a  serious  accounting  error  has  occurred  which 
affects  one  of  the  most  important  figures  shown  by  the  records, 
net  revenue. 

This  does  not  mean  that  the  auditor  should  neglect  numerical 
and  other  clerical  inaccuracies.  Such  errors  are  serious  from  a 
certain  viewpoint.  The  bookkeeper,  for  example,  may  carelessly 
credit  the  wrong  customer's  account  with  the  amount  of  a  pay- 
ment, or  may  credit  a  creditor's  account  instead  of  an  account 
receivable,  or  may  even  omit  one  side  of  the  entry  entirely; 
and  any  such  error  might  cause  considerable  confusion  and  a 
misunderstanding  between  the  parties  to  the  transaction  im- 
properly recorded.  But  all  such  clerical  mistakes  tend  to  be 
more  or  less  self-corrective,  and  their  location  and  adjustment 
is  a  secondary  part  of  the  auditor's  work. 

It  has  been  implied  in  the  foregoing  discussion  that  it  is  the 
task  of  the  auditor  to  make  examinations  of  financial  records. 
The  point  should  be  emphasized,  however,  that  an  important 
purpose  of  an  audit  is  the  discovery  of  facts  not  recorded.  There 
may  be  no  record  of  accrued  liabilities,  for  example,  or  certain 
revenue  items  may  be  omitted.  Further,  some  of  the  assets 
owned  may  not  appear  in  the  accounts.  It  is  the  function  of 
the  auditor  to  locate  all  such  items  and  include  them  in  the  state- 
ments prepared  so  that  a  true  picture  of  the  financial  condition 
of  the  enterprise  under  audit  may  be  presented. 

Contingent  assets  and  liabilities  are  important  matters  for 
the  auditor  to  consider.  Contingencies  are  not  accounting 
transactions  in  the  ordinary  sense  and  need  not  be  entered  in  the 


AUDITING  647 

regular  financial  accounts ;  for  obviously  it  is  the  function  of  the 
accounts  to  present  a  record  of  actual  transactions  and  value 
changes  and  not  of  anticipated  occurrences.  But  an  ordinary 
balance  sheet  statement  of  assets  and  equities  is  not  an  entirely 
satisfactory  statement  for  the  prospective  creditor  or  investor. 
The  probable  future  financial  condition  of  the  enterprise  is  a 
matter  of  importance ;  and  contingent  assets  and  liabilities,  if 
they  represent  definite  possibilities,  have  a  bearing  upon  this 
condition.  Indorsed  notes,  guarantees  in  connection  with  the 
sale  of  goods,  pending  damage  claims,  guarantees  of  principal 
or  income  in  connection  with  the  security  issues  of  subsidiary 
companies  —  these  are  common  examples  of  contingent  liabilities. 
Possible  stock  assessments,  claims  against  railroad  companies  or 
other  disputed  rights,  are  examples  of  contingent  assets.  A 
satisfactory  auditor's  report  will  include  a  statement  of  all 
such  items. 

While  it  may  not  be  reasonable  to  consider  the  auditor  a 
valuation  expert,  nevertheless  he  must  pass  upon  and  test 
valuations.  In  connection  with  securities,  accounts  receivable, 
patents,  goodwill,  and  other  intangibles,  it  is  usually  the  auditor, 
after  consultation  with  the  manager  or  owner,  who  sets  the  actual 
valuations.  Further,  he  must  be  familiar  with  depreciation 
rates  and  methods  of  taking  inventory.  Above  all  the  auditor 
should  take  a  conservative  position  in  regard  to  all  valuation. 
It  is  a  natural  tendency  of  business  managements  to  overstate 
values  in  their  anxiety  to  make  a  favorable  showing.  The 
development  of  income  and  excess  profit  taxes  has  offset  this 
tendency  to  some  extent,  but  it  still  exists.  This  does  not  mean 
that  the  auditor  need  adopt  an  illogical  policy.  Rules  for 
valuations  should  be  logically  formulated  but  conservatively 
applied.  In  view  of  the  present  prejudice  in  favor  of  an  illogical 
basis  for  valuations  (see  Chapter  XX)  it  may  be  wise  for  an 
auditor  to  follow  prevailing  practice  in  presenting  the  audited 
balance  sheet  proper.  By  means  of  footnotes  and  supple- 
mentary statements,  however,  the  auditor  may  make  clear  to 
all  interested  the  actual  financial  condition  of  the  enterprise 
as  he  finds  it.  If  the  auditor's  report  does  not  present  actual 
condition  in  some  way  such  a  report  cannot  serve  the  purposes 
intended. 


648  PRINCIPLES  OF  ACCOUNTING 

As  was  explained  in  the  preceding  section  an  audit  is  usually 
conducted  for  some  definite  purpose.  The  auditor's  report, 
accordingly,  should  be  prepared  in  such  a  way  as  to  throw  the 
greatest  possible  light  upon  the  particular  problem  involved. 
A  balance  sheet  of  a  certain  company,  for  example,  prepared  for 
a  banker  who  is  considering  making  a  short-term  loan  to  the 
company,  should  show  the  liquid  assets  as  the  first  group  of 
asset  items;  and  the  current  liabilities  should  be  similarly 
segregated  in  a  prominent  position  so  that  a  comparison  between 
the  two  groups  can  easily  be  made.  The  stockholder,  on  the 
other  hand,  may  be  more  interested  in  the  fixed  assets  and  the 
amount  of  the  proprietary  equity.  If  this  is  the  case  these  facts 
should  be  clearly  set  forth.  Accurate  classification  in  view  of  a 
particular  purpose  is  an  important  phase  of  auditing.  If  there 
are  several  interests  involved  the  auditor  may  prepare  a  whole 
sheaf  of  income  and  balance  sheets,  each  of  which  statements 
stresses  a  certain  aspect  of  the  business,  and  certain  relations 
between  the  financial  data  involved.  (See  the  chapters  on 
statements.)  This  does  not  at  all  mean,  however,  that  the  pro- 
fessional accountant  should  twist  or  misconstrue  the  facts  in  the 
interest  of  a  particular  client. 

Often  the  auditor  has  to  deal  not  only  with  clerical  inaccuracies 
and  errors  in  accounting  analysis  but  also  with  fraud.  The 
most  common  fraud  is  the  misappropriation  of  cash  or  similar 
assets.  It  is  especially  because  of  this  fact  that  an  auditor  should 
exercise  tact  and  discretion  in  his  relations  with  the  officials 
and  employees  of  the  enterprise  whose  books  are  being  examined. 
It  is  his  duty  to  obtain  the  facts  even  if  these  facts  are  not  to 
the  advantage  of  his  client.  When  embezzlements  are  made 
by  an  officer  or  employee  who  has  access  to  the  records  it  is  quite 
possible  that  the  theft  may  be  covered  up  so  ingeniously  as 
to  make  detection  very  difficult.  The  manipulation  of  sales 
and  accounts  receivable  figures  is  the  means  most  commonly 
employed  to  eliminate  the  evidence  of  defalcations.  Mis- 
appropriations are  particularly  hard  to  detect  in  the  case  of  small 
businesses  where  a  single  officer  or  employee  has  access  to  or 
control  over  all  the  records.  The  system  of  internal  check  in 
force  in  large  offices  tends  to  prevent  such  occurrences.  The 
various  methods  of  detecting  errors  and  fraud  are  a  part  of  the 


AUDITING  649 

technique  of  auditing,  however,  and  a  consideration  of  these 
matters  is  beyond  the  scope  of  this  discussion. 

It  should  be  evident  from  this  brief  statement  of  the  nature  and 
purposes  of  auditing  that  the  successful  auditor  needs  a  thorough 
training  in  theory  and  an  extensive  practical  accounting  expe- 
rience. He  needs  an  exhaustive  knowledge  of  accounting 
principles  since  the  examination  of  the  financial  statistics  of  a 
modern  business  enterprise  involves  the  knowledge  of  all  the 
accounting  principles  upon  which  such  records  are  based  and  to 
which  they  should  conform ;  and  he  evidently  requires  a  thorough 
familiarity  with  the  particular  types  of  records  used  in  various 
kinds  of  business  such  as  manufacturing,  trading,  banking,  etc. 
Each  industry  —  and  even  each  particular  enterprise  —  has  its 
own  peculiar  accounting  problems  and  requires  a  more  or  less 
unique  system  of  records.  A  knowledge  of  the  main  features 
of  business  operation  in  the  various  important  fields  and  of  the 
accounting  technique  suited  to  these  special  cases  can  only  be 
secured  in  an  adequate  degree  through  actual  experience. 

Again,  the  work  an  auditor  is  called  upon  to  do  involves  many 
questions  of  business  law  and  finance;  and  hence  a  general 
knowledge  of  these  subjects  is  invaluable.  Finally,  the  auditor 
should  be  able  to  express  his  findings  with  such  clearness  and 
simplicity  that  they  may  be  readily  appreciated  by  any  interested 
parties. 


APPENDICES 


THE  TREATMENT  OF  CASH  DISCOUNTS 

THE  cash  discount  accounts  as  ordinarily  kept  have  been 
classed  in  this  text  as  valuation  accounts.  The  Purchase  Dis- 
counts account  shows  the  amount  by  which  merchandise  or 
material  costs  have  been  overstated,  and  the  Sales  Discounts 
account  shows  the  deduction  from  the  gross  sales  figure  resulting 
from  the  allowances  made  for  prompt  cash  payments.  At 
several  points  in  the  preceding  pages  the  nature  of  discounts 
has  been  discussed  and  the  question  of  the  proper  location  of  such 
items  in  the  summary  statements  was  briefly  considered  in 
Chapter  IX.  While  the  analysis  that  has  been  given  is  essentially 
correct  the  method  of  making  the  entries  used  may  be  criticized 
because  it  fails  to  recognize  neglected  discounts  in  the  accounts. 
The  common  method  of  making  the  entries  also  makes  the  valua- 
tion at  which  the  merchandise  or  materials  purchased  is  carried 
in  the  accounts  depend  upon  whether  or  not  the  purchaser 
takes  the  discounts  offered.  This  last  criticism  is  not  so  im- 
portant as  it  might  seem  at  first  sight  because  merchandise  and 
raw  materials  usually  pass  so  rapidly  through  the  business 
process  that  these  items  soon  become  costs ;  and  it  is  certainly 
true  that  a  firm  which  does  not  take  its  discounts  has  a  higher 
merchandise  cost  than  one  which  does.  The  recognition  of 
neglected  discounts,  however,  is  a  matter  of  some  theoretic 
importance  at  least.  While  it  is  true  that  in  many  cases  the 
amount  of  cash  discounts  is  relatively  unimportant  it  must  be 
recognized  that  accounting  attempts  to  present  the  actual  facts 
as  accurately  as  possible.  With  this  idea  in  view  it  may  be 
well  to  examine  an  alternative  method  of  treating  cash  discounts. 

A  possible  method  would  be  to  provide  special  accounts  for 
discounts  neglected  but  none  for  discounts  taken.1  According 

1  Cf.  Cole,  Accounts,  Their  Construction  and  Interpretation,  Chapter  Twenty-one. 

653 


654  PRINCIPLES  OF  ACCOUNTING 

to  this  method  it  is  more  important  to  know  how  much  has  been 
lost  in  discounts  than  how  much  has  been  taken ;  and  this  fact 
evidently  cannot  be  determined  from  the  ordinary  discount 
accounts.  The  fact  that  a  discount  has  been  neglected  indicates 
that  the  firm  is  operating  with  insufficient  working  capital  and 
is  therefore  unable  to  meet  its  bills  promptly.  The  amount  of 
the  neglected  discount  is  in  fact  an  interest  payment  as  was 
pointed  out  in  Chapter  XIV.  The  firm  is  paying  its  creditor 
interest  for  carrying  the  account.  Accordingly,  since  interest 
is  neither  a  property  item  nor  an  expense,  but  is  rather  a  charge 
against  net  revenue,  it  is  obviously  incorrect  to  charge  discounts 
to  the  merchandise  accounts. 

According  to  this  method  goods  purchased  are  always 
entered  at  the  discounted  price.  This  procedure  can  best  be 
explained  by  an  illustration.  Suppose  a  firm  buys  merchandise 
with  a  gross  price  of  $1,000,  two  per  cent  off  if  paid  in  ten  days. 
The  discounted  price  is  then  $980.  The  entries  at  the  date  of 
purchase  would  accordingly  be : 

Merchandise $980 

Accounts  Payable $  980 

When  payment  is  made,  if  within  ten  days,  the  entries  would  be  : 

Accounts  Payable $980 

Cash $  980 

If  the  bill  were  not  paid  within  the  specified  discount  period, 
however,  the  entries  covering  the  payment  would  be  as  follows : 

Accounts  Payable $980 

Neglected  Purchase  Discounts     ....        20 

Cash $1,000 

The  Neglected  Purchase  Discounts  account  would  be  closed 
into  Net  Revenue  (or  Expense  and  Revenue)  as  is  any  interest 
account.  By  this  method  merchandise  purchases  will  always  be 
entered  at  the  cash  price  regardless  as  to  whether  prompt  pay- 
ment is  made  or  not.  No  adjustment  of  expense  is  required 
because  of  discounts  taken,  but  an  interest  charge  is  made  for 
all  discounts  neglected. 


APPENDIX  A  655 

It  is  sometimes  objected  to  this  method  that  the  invoice 
price  should  be  credited  to  Accounts  Payable  at  the  date  of 
purchase.  In  other  words  where  alternative  terms  of  settlement 
are  allowed  the  gross  liability  should  be  carried  in  the  accounts. 
It  might  be  argued  against  this  objection  that  no  real  purpose 
is  served  by  carrying  the  gross  invoice  price  through  the  accounts. 
The  actual  accounting  liability  at  the  date  of  the  transaction  is 
the  cash  price  and  this  increases  only  through  lapse  of  time. 
This  situation  is  not  peculiar  to  accounts  payable ;  the  same  is 
true  of  notes  and  bonds.  If,  however,  it  be  desired  in  the  case 
of  accounts  payable  to  adhere  to  the  almost  universal  custom  of 
listing  liabilities  in  the  accounts  at  face  or  gross  amount  the 
invoice  price  may  be  carried  in  the  accounts  without  changing 
the  results  of  this  method.  At  the  date  of  purchase,  for  example, 
the  entries  for  the  above  illustration  might  be  : 

Merchandise $   980 

Purchase  Discounts  Offered      ....  20 

Accounts  Payable $1,000 

Purchase  Discounts  Offered  is  a  valuation  account  which  shows 
the  amount  by  which  the  item  appearing  in  Accounts  Payable 
exceeds  the  actual  present  liability.  At  the  date  of  payment  if 
the  discount  is  taken  the  entries  would  be : 

Accounts  Payable       $1,000 

Cash ,  $   980 

Purchase  Discounts  Offered  20 

If  the  discount  were  not  taken  the  entries  would  be : 

Accounts  Payable       $1,000 

Cash $1,000 

In  the  case  of  discounts  on  sales  the  same  analysis  would  hold. 
Here  the  Neglected  Sales  Discounts  account  would  show  a  credit 
balance  which  would  represent  an  interest  revenue.  That  is,  the 
customers  who  failed  to  meet  their  bills  promptly  would  be 
paying  interest  on  their  accounts. 

While  this  method  of  treating  purchase  and  sales  discounts 


656  PRINCIPLES  OF  ACCOUNTING 

conforms  more  nearly  to  correct  accounting  principles  it  is  very 
seldom  used ;  and,  as  already  explained,  present  practice  in  this 
connection  accomplishes  essentially  correct  results.  It  is  also 
somewhat  unreasonable,  in  view  of  the  nature  of  discount 
rates,  to  consider  neglected  discounts  as  either  income  or  deduc- 
tions from  income.  Further,  this  method  requires  an  estimate 
at  the  end  of  each  accounting  period  of  the  amounts  of  both 
purchase  and  sales  discounts,  applicable  to  accounts  unpaid 
and  not  yet  due,  which  will  finally  be  taken  ;  and  the  difficulties 
involved  in  this  procedure  are  such  as  to  render  this  method,  as 
a  rule,  inexpedient. 


B 

INTEREST  TABLES 


658  PRINCIPLES  OF  ACCOUNTING 

TABLE  I 

Amount  to  which  i  will  accumulate  in  n  periods 
s  =  (i  +  *)" 


*    Ij% 

ij% 

t% 

»i  %         3  % 

I     .012  5000 

1.015  oooo 

I.  O2O  OOOO 

1.0250006      .0300000 

2       .025  1563 

1.030  2250 

.040  4000 

1.050  6250      .060  9000 

3     -°37  9707 

1.045  6784 

.061  2080 

1.076  8906      .092  7270 

4     -050  9453 

1.  06  1  3636 

.082  4322 

1.103  8129      .125  5088 

5     .064  0822 

1.077  2840 

.104  0808 

1.131  4082      .159  2741 

6     .077  3832 

1.093  4433 

.126  1624 

1.1596934      .1940523 

7     .090  8505 

1.109  8449 

.148  6857 

1.188  6858      .229  8739 

8     .104  4861 

1.126  4926 

.171  6594 

i.  218  4029      .266  7701 

9     .118  2922 

1.143  3900 

.195  0926 

1.248  8630      .304  7732 

10     .132  2708 

1.160  5408 

.218  9944 

1.280  0845      -343  9164 

ii     .1464242 

1.1779489 

•243  3743 

1.3120867      -3842339 

12     .160  7545 

1.195  6182 

1.268  2418 

1.344  8888      .425  7609 

13     -175  2639 

1.213  5524 

1.293  6066 

1.3785110      -4685337 

14     .189  9547 

1-231  7557 

1.3194788 

1.412  9738      .512  5897 

15     .204  8292 

1.250  2321 

1-345  8683 

1.448  2982      .557  9674 

16     .219  8895 

1.268  9855 

1-372  7857 

1.484  5056      .604  7064 

i?     -235  1382 

1.288  0203 

1.400  2414 

1.521  6183      .652  8476 

18     .250  5774 

1.307  3406 

1.428  2463 

r-559  6587      -702  4331 

19     .266  2096 

1.326  9507 

1.456  8112 

1.598  6502      .753  5061 

20    1.282  0372 

1.346  8550 

1.485  9474 

1.638  6164        .806  1  1  12 

21      I.298OO27 

1.367  0578 

1.515  6663 

1.679  58l9        -860  2946 

22      I.3I4  2885 

1-387  5637 

J-545  9797 

I.72I  5714       1.916  1034 

23      1-330  7171 

1.408  3771 

1.576  8993 

1.764  6107     '  1.973  5865 

24    1-347  35ir 

1.429  5028 

i.  608  4373 

1.  808  7260       2.032  7941 

25    1.364  1929 

1.450  9454 

1.640  6060 

1.853  9441       2.093  7780 

26    1.381  2454 

1.472  7095 

1.673  4i8i 

1.900  2927       2.156  5913 

27    1.398  5!°9 

1.494  8002 

1.706  8865 

1.947  80OO       2.221  2890 

28    1.415  9923 

I.5I7  2222 

1.741  0242 

1.996  4950       2.287  9277 

29    1.433  6922 

1.539  9805 

1.775  8447 

2.046  40/4       2.356  5655 

30    1.451  6134 

1.563  0802 

.811  3616 

2.097  5676       2.427  2625 

31    1.469  7585 

1.586  5264 

.847  5888 

2.1500068       2.5000803 

32    1.488  1305 

1.610  3243 

.884  5406 

2.203  7569       2.575  0828 

33    1-506  7321 

1.634  4792 

.922  2314 

2.258  8509       2.652  3352 

34    1-525  5663 

1.658  9964 

.960  6760 

2.315  3221       2.731  9053 

35    1-544  6359 

1.683  8813 

.999  8896 

2-373  2052       2.813  8625 

36    1.563  9438 

1.709  1395 

2.039  8873 

2.432  5353     2.898  2783 

37    1.583  4931 

1.734  7766 

2.080  6851 

2.493  3487     2.985  2267 

38    1.603  2868 

1.760  7983 

2.122  2988 

2.555  6824     3.074  7835 

39    1.623  3279 

1.787  2102 

2.164  7448 

2.619  5745     3.167  0270 

40    1.643  6195 

1.814  0184 

2.2O8  0397 

2.685  0638     3.262  0378 

41    1.664  *647 

1.841  2287 

2.252  2OO5 

2.752  1004     3.359  8989 

42    1.684  9668 

1.868  8471 

2.297  2445 

2.820  9952     3-46o  6959 

43    1.706  0289 

1.896  8798 

2.343  1894 

2.891  5201     3.564  5168 

44    I-7273542 

1-925  3330 

2-390  0531 

2.963  8081     3.671  4523 

45    1.748  9461 

1.954  2130 

2.437  8542 

3.037  9033     3.781  5958 

46  '   1.770  8080 

1.983  5262 

2.486  6lI3 

3.1138509     3.8950437 

47    1.792  9431 

2.013  2791 

2-536  3435 

3.191  6971     4.011  8950 

48    1.815  3549 

2.043  4783 

2.587  0704 

3.271  4896     4.132  2519 

49    i  .838  0468 

2.074  1305 

2.638  8118 

3-353  2768     4.256  2194 

50    1.861  0224 

2.105  2424 

2.691  5880 

3.437  1087     4.383  9060 

APPENDIX  B 

TABLE  I 

Amount  to  which  i  will  accumulate  in  n  periods 
s=(i  +  i)n 


659 


34% 

4% 

44% 

5% 

6% 

n 

L035 

oooo 

.040  oooo 

1.045  oooo 

.050  oooo 

i  .060  oooo 

I 

1.071 

2250 

.081  6000 

1.092  0250 

.102  5000 

1.123  6000 

2 

i.ioS 

7179 

.124  8640 

1.141  1661 

.157  6250 

1.191  0160 

3 

1.147 

5230 

.169  8586 

1.192  5186 

.215  5063 

1.262  4770 

4 

1.187 

6863 

.216  6529 

1.246  1819 

.276  2816 

1.338  2256 

5 

1.229 

2553 

.265  3190 

1.302  2601 

.340  0956 

1.418  5191 

6 

1.272 

2793 

•3159318 

1.360  8618 

.407  1004 

1.503  6303 

7 

1.316  8090 

.368  5691 

1.422  1006 

•477  4554 

1.593  8481 

8 

1.362 

8974 

.423  3118 

1.486  0951 

•551  3282 

1.689  4790 

9 

1.410 

5988 

.480  2443 

1.552  9694 

1.628  8946 

1.790  8477 

10 

1.459  9697 

•539  454i 

1.622  8530 

1.710  3394 

1.898  2986 

ii 

1.511 

0687 

.601  0322 

1.695  8814 

1-795  8563 

2.OI2  1965 

12 

1-563 

9561 

•665  0735 

1.772  1961 

1.885  6491 

2.132  9283 

13 

1.6  1  8  6945 

.731  6764 

1.851  9449 

1.979  9316 

2.26O  9040 

14 

1.675  3488 

.800  9435 

1.935  2824 

2.078  9282 

2.396  5582 

15 

1-733 

9860 

.872  9812 

2.O22  3702 

2.182  8746 

2.5403517 

16 

1.794  6756 

•947  9005 

2.II3  3768 

2.292  0183 

2.692  7728 

17 

1.857  4892    2.025  8165 

2.208  4788 

2.406  6192 

2-854  3392 

18 

1.922 

5013    2.106  8492 

2.307  8603 

2.526  9502 

3-025  5995 

19 

1.989 

7889    2.191  1231 

2.4II  7I4O 

2-653  2977 

3.207  1355 

20 

2.059  4315    2.278  7681 

2.52O  2412 

2.785  9626 

3-399  5636 

21 

2.131 

5116    2.369  9188 

2.633  6520 

2.925  2607 

3-603  5374 

22 

2.206 

1145   2.464  7155 

2.752  1663 

3.071  5238 

3.819  7497 

23 

2.283  3285    2.563  3042 

2.876  0138 

3.225  0999 

4.048  9346 

24 

2-363 

2450    2.665  8363 

3.005  4345 

3.386  3549 

4.291  8707 

25 

2.445  9586    2.772  4698 

3.140  6790 

3-555  6727 

4-549  3830 

26 

2-531 

5671   2.883  3686 

3.282  0096 

3-733  4563 

4-822  3459 

27 

2.620 

1720   2.998  7033 

3.429  7000 

3.920  1291 

5.111  6867 

28 

2.711 

8780   3.1186515 

3.584  0365 

4.116  1356 

5.418  3879 

29 

2.806 

7937    3-243  3975 

3.745  3181 

4.321  9424 

5-743  4912 

30 

2.905  0315    3-373  1334 

3.9I3  8575 

4.538  0395 

6.088  1006 

31 

3.006 

7076    3.508  0587 

4.089  9810 

4.764  9415 

6-453  3867 

32 

3.111  9424    3.648  3811 

4.2740302 

5.003  1885 

6.840  5899 

33 

3.2208603    3-7943163 

4.466  3615 

5.253  3480 

7.251  0253 

34 

3-333 

5904    3.946  0890 

4.667  3478 

5.5160154 

7.686  0868 

35 

3-450 

2661    4.103  9326 

4.877  3785 

5.791  8161 

8.147  2520 

36 

3-571 

0254    4.268  0899 

5.096  8605 

6.081  4069 

8.636  0871 

37 

3.6960113    4.4388135 

5.326  2192 

6.385  4773 

9.154  2523 

38 

3-825 

3717    4.6163660 

5.565  8991 

6.704  7512 

9-703  5075 

39 

3-959 

2597    4.801  0206 

5.816  3645 

7.039  9887 

10.285  7XI9 

40 

4.097 

8338    4.993  0615 

6.078  1009 

7.391  9881 

10.902  8610 

41 

4.241 

2580    5.192  7839 

6.351  6155 

7.761  5876 

"-5570327 

42 

4-389 

7020    5.400  4953 

6.637  4382 

8.149  6669 

12.2504546 

43 

4-543  34i6    ^ 

-.616  5151 

6.936  1229 

8-557  1503 

12.985  4819 

44 

4.702 

3586    5.841  1757 

7.248  2484 

8.985  0078 

13.764  6108 

45 

4.866  9411    6.074  8227 

7.574  4196 

9.434  2582 

14.590  4875 

46 

5-037 

2840    6.317  8156 

7.915  2685 

9.905  9711 

15.465  9167 

47 

5-213 

5890    6.570  5282 

8.271  4556 

10.401  2696 

16.393  8717 

48 

5.396  0646    6.833  3494 

8.643  6711 

10.921  3331 

17-377  5040 

49 

5.584  9269    7.106  6833 

9.032  6363 

11.467  3998 

18.420  1543 

50 

66o 


PRINCIPLES  OF  ACCOUNTING' 

TABLE  II 
Present  value  of  i  due  in  n  periods 


f  =  — 

• 

ii% 

ii% 

2% 

2i% 

3% 

I 

0.987  6543 

0.985  2217 

0.980  3922 

O.975  6098 

0.970  8738 

2 

0.9754611 

0.970  6617 

0.961  1688 

O.95I  8l44 

0-942  5959 

3 

0.963  4183 

0.956  3170 

0.942  3223 

0.928  5994 

0.915  1417 

4 

0.951  5243 

0.942  1842 

0.923  8454 

0.905  9506 

0.888  4870 

5 

0.939  7771 

0.928  2603 

0.905  7308 

0.883  8543 

0.862  6088 

6 

0.928  1749 

0.914  5422 

0.887  97*4 

0.862  2969 

0.837  4843 

7 

0.916  7159 

0.901  0268 

0.870  5602 

0.841  2652 

0.813  0915 

8 

0.905  3985 

0.887  7111 

0.853  4904 

0.820  7466 

0.789  4092 

9 

0.894  2207 

0.874  5922 

0-836  7553 

0.800  7284 

0.766  4167 

10 

0.883  1809 

0.861  6672 

0.820  3483 

0.781  1984 

0.744  0939 

ii 

0.872  2775 

0.848  9332 

0.804  2630 

0.762  1448 

0.722  4213 

12 

0.861  5086 

0.836  3874 

0.788  4932 

0-743  5559 

0.701  3799 

13 

0.850  8727 

0.824  0270 

0-773  0325 

0.725  4204 

0.680  9513 

14 

0.840  3681 

0.811  8493 

0-757  8750 

0.707  7272 

0.661  1178 

15 

0.829  9932 

0.799  8515 

0.743  0147 

0.690  4656 

0.641  8619 

16 

0.819  7463 

0.788  0310 

0.7284458 

0.673  6249 

0.623  J66g 

17 

0.809  6260 

0.776  3853 

0.714  1626 

0.657  1951 

0.605  0164 

18 

0.799  6306 

0.764  9116 

0.700  1594 

0.641  1659 

0.587  3946 

19 

0.789  7587 

0.756  6075 

0.686  4308 

0.625  5277 

0.570  2860 

20 

0.780  0085 

0.742  4704 

0.672  9713 

0.610  2709 

0-553  6758 

21 

0.7703788 

0.731  4980 

0.659  7758 

0-595  3863 

0-537  5493 

22 

0.760  8680 

0.720  6876 

0.646  8390 

0.580  8647 

0.521  8925 

23 

0.751  4745 

0.7100371 

0.634  1559 

0.566  6972 

0.506  6917 

24 

0.742  1971 

0.699  5439 

0.621  7215 

0.552  8754 

0.491  9337 

25 

0-733  0341 

0.689  2058 

0.609  5309 

0-539  3906 

0.477  6056 

26 

0.723  9843 

0.679  0205 

0-597  5793 

0.526  2347 

0.463  6947 

27 

0.715  0463 

0.668  9857 

0.585  8620 

0.513  3997 

0.450  1891 

28 

0.706  2185 

0.659  0993 

0-574  3746 

0.500  8778 

0.437  0768 

29 

0.697  4998 

0.649  3589 

0.563  1123 

0.488  6613 

0.424  3464 

30 

0.688  8887 

0.639  7624 

0.552  0709 

0.476  7427 

0.411  9868 

31 

0.680  3839 

0.630  3078 

0.541  2460 

0.465  1148 

0.399  9871 

32 

0.671  9841 

0.620  9929 

0.530  6333 

0-453  7705 

0.388  3370 

33 

0.663  6880 

0.611  8157 

0.520  2287 

0.442  7030 

0.377  0262 

34 

0.655  4943 

0.602  7741 

0.510  0282 

0.431  9053 

0.366  0449 

35 

0.647  4018 

0.593  8661 

0.500  0276 

0.421  3711 

0-355  3834 

36 

0.639  4092 

0.585  0897 

0.490  2232 

0.411  0937 

0.345  0324 

37 

0.631  5152 

0.5764431 

0.480  6109 

0.401  0670 

0.334  9829 

38 

0.623  7*87 

0.567  9242 

0.471  1872 

0.391  2849 

0.325  2262 

39 

0.616  0185 

0-559  5313 

0.461  9482 

0.381  7414 

0.315  7535 

40 

0.608  4133 

0.551  2623 

0.452  8904 

0.372  4306 

0.306  5568 

41 

0.600  9021 

0-543  "56 

0.444  OIO2 

0.363  3469 

0.297  6280 

42 

0-593  4835 

0-535  0893 

0-435  3041 

0.354  4848 

0.288  9592 

43 

0.586  1566 

0.527  1815 

0.426  7688 

0-345  8389 

0.280  5429 

44 

0.578  9201 

0.519  3907 

0.418  4007 

0.337  4038 

0.272  3718 

45 

0.571  7729 

0.511  7149 

0.410  1968 

0.329  1744 

0.264  4386 

46 

0.564  7140 

0.504  1527 

0.402  1537 

0.321  1458 

0.256  7365 

47 

0.557  7422 

0.496  7021 

0.394  2684 

0.313  3129 

0.249  2588 

48 

0-550  8565 

0.489  3617 

0.386  5376 

0.305  6712 

0.241  9988 

49 

0-544  0558 

0.482  1298 

0.378  9584 

0.298  2158 

0.234  95°3 

50. 

0-537  3391 

0.475  0047 

0.371  5279 

0.290  9422 

0.228  0171 

APPENDIX  B 

TABLE  II 

Present  value  of  i  due  in  n  periods 


661- 


3i% 

4% 

4i% 

s% 

6% 

n 

0.966  1836 

0.961  5385 

0-956  9378 

0.952  3810 

0.943  3962 

I 

0-933  5I07 

0.924  5562 

0.915  7300 

0.907  0295 

0.889  9964 

2 

0.901  9427 

0.888  9964 

0.876  2966 

0.863  8376 

0.839  6193 

3 

0.871  4422 

0.854  8042 

0.838  5613 

0.822  7025 

0.792  0937 

4 

0.841  9732 

0.821  9271 

0.802  4510 

0.783  5262 

0.747  2582 

5 

0.813  5006 

0.790  3  H5 

0.767  8957 

0.746  2154 

0.704  9605 

6 

0.785  9910 

0.759  9!78 

0.734  8285 

0.710  6813 

0.665  0571 

7 

0.7594116 

0.730  6902 

0.703  1851 

0.676  8394 

0.627  4124 

8 

0-733  73  10 

0.702  5867 

0.672  9044 

0.644  6089 

0.591  8985 

9 

0.708  9188 

0.675  5642 

0.643  9277 

0.613  9133 

0.558  3948 

10 

0.684  9457 

0.649  5809 

0.616  1987 

0.584  6793 

0.526  7875 

ii 

0.66  1  7833 

0.624  5970 

0.589  6639 

0.556  8374 

0.496  9694 

12 

0.639  4042 

0.600  5741 

0.564  2716 

0.530  3214 

0.468  8390 

T3 

0.617  7818 

0-577  4751 

0.539  9729 

0.505  0680 

0.442  3010 

T4 

0.596  8906 

o-555  2645 

0.516  7204 

0.481  0171 

0.417  2651 

15 

0.576  7059 

0.533  9082 

0.494  4693 

0.458  1115 

0.393  6463 

16 

0.557  2038 

0-513  3732 

0.473  1764 

0.436  2967 

0.371  3644 

17 

0.5383611 

0.493  6281 

0.452  8004 

0.415  5207 

0.350  3438 

18 

0.520  1557 

0.474  6424 

0-433  3018 

0.395  7340 

0.330  5130 

ig 

0.502  5659 

0.456  3869 

0.414  6429 

0.376  8895 

0.311  8047 

2O 

0.485  5709 

0.438  8336 

0.396  7874 

0.358  9424 

0.294  1554 

21 

0.469  1506 

0.421  9554 

0.379  7009 

0.341  8499 

0.277  5051 

22 

0.453  2856 

0.405  7263 

0.363  35oi 

0.325  5713 

0.261  7973 

23 

0-437  9571 

0.390  1215 

0-347  7035 

o-.3io  0679 

0.246  9785 

24 

0.423  1470 

0.375  "68 

0.332  7306 

0.295  3028 

0.232  9986 

25 

0.408  8377 

0.360  6892 

0.318  4025 

0.281  2407 

0.219  8100 

26 

0.395  OI22 

0.346  8166 

0.304  6914 

0.267  8483 

0.207  3679 

27 

0.381  6543 

o-333  4775 

0.291  5707 

0.255  0936 

0.195  6301 

28 

0.368  7482 

0.320  6514 

0.279  OI5° 

0.242  9463 

0.184  5567 

29 

0.356  2784 

0.308  3187 

0.267  oooo 

0.231  3774 

0.174  not 

30 

0.344  2303 

0.296  4603 

0.255  5024 

0.220  3595 

0.164  2548 

31 

0.332  5897 

0.285  0579 

0.244  4999 

0.209  8662 

°-I54  9574 

32 

0.321  3427 

0.274  0942 

°-233  97*2 

0.199  8725 

0.146  1862 

33 

0.310  4761 

0.263  5521 

0.223  8959 

0.190  3548 

0.137  9115 

34 

0.299  9769 

0.253  4155 

0.214  2544 

0.181  2903 

0.130  1052 

35 

0.289  8327 

0.243  6687 

0.205  0282 

0.172  6574 

O.I  22  7408 

36 

0.280  0316 

0.234  2968 

0.196  1992 

0.164  4356 

O.II5  7932 

37 

0.270  5619 

0.225  2854 

0.187  7504 

0.156  6054 

O.lOg  2389 

38 

O.26l  4125 

0.216  6206 

0.179  6655 

0.149  I48o 

0.103  0555 

39 

0.252  5725 

0.208  2890 

0.171  9287 

0.142  0457 

O.O97  2222 

40 

0.244  0314 

O.20O  2779 

0.164  5251 

0.135  2816 

O.O9I  7190 

0.235  7791 

0.192  5749 

0.1574403 

0.128  8396 

O.O86  5274 

42 

0.227  8059 

0.185  1682 

0.150  6605 

O.I22  7044 

O.oSl  6296 

43 

O.22O  IO23 

0.178  0463 

0.144  X728 

0.116  8613 

O.O77  OO9I 

44 

O.2I2  6592 

0.171  1984 

0.137  9644 

o.i  1  1  2965 

O.O72  6501 

45 

0.205  4679 

0.164  6139 

0.132  0233 

0.105  9967 

0.068  5378 

46 

0.198  5197 

0.158  2826 

0.126  3381 

o.ioo  9492 

0.064  6583 

47 

O.igi  8065 

0.152  1948 

0.120  8977 

0.096  1421 

O.O6O  9984 

48 

0.185  32O2 

0.146  3411 

0.115  6916 

0.091  5639 

0.057  5457 

49 

0.179  0534 

0.140  7126 

o.no  7096 

0.087  2037 

0.054  2884 

So 

'662  PRINCIPLES  OF  ACCOUNTING 

TABLE  III 

Sum  /<>  which  an  annuity  of  i  per  year  -mil  accumulate  in  n  periods 


Sn  = 

.  (i  +  0-  -  i 

i 

n 

il% 

Ij% 

•  % 

•»% 

3% 

I 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

2 

2.OI2  5OOO 

2.015  oooo 

2.O2O  OOOO 

2.025  oooo 

2.030  oooo 

3 

3.037  6562 

3.045  2250 

3.060  4OOO 

3.075  6250 

3.090  QOOO 

4 

4.075  6269 

4.090  9034 

4-I2I  6080 

4-152  5156 

4.183  6270 

S 

5.126  5723 

5.152  2669 

5.2O4  O4O2 

5.256  3285 

5-309  1358 

6 

6.190  6544 

6.229  55°9 

6.308  I2IO 

6.387  7367 

6.468  4099 

7 

7.268  0376 

7.322  9942 

7.434  2834 

7.547  4301 

7.662  4622 

8 

8.358  8881 

8.432  8391 

8.582  9691 

8.736  1159 

8.892  3360 

9 

9-463  3742 

9-55933I7 

9-754  6284 

9.954  5188 

10.159  J°6i 

10 

10.581  6664 

10.702  7217 

10.949  7210 

11.203  3818 

11.463  8793 

ii 

"•713  9372 

11.863  2625 

I2.'i68  7154 

12.483  4663 

12.807  7957 

12 

12.860  3614 

13.041  2114 

13.412  0897 

13-795  5530 

14.192  0296 

13 

14.021  1159 

14.236  8296 

14.6803315 

15.1404418 

15.617  7904 

14 

15-196  3799 

15.450  3820 

15-973  9382 

16.518  9528 

17.086  3242 

15 

16.386  3346 

16.682  1378 

17.293  4169 

17.931  9267 

18.598  9139 

16 

17.591  1638 

I7-932  3698 

18.639  2853 

19.380  2248 

20.156  8813 

17 

18.811  0534 

19.201  3554 

2O.OI2  O7IO 

20.864  7304 

21.761  5877 

18 

20.046  1915 

20.489  3757 

21.412  3124 

22.386  3487 

23.4H  4354 

iQ 

21.296  7689 

21.796  7164 

22.840  5586 

23.946  0074 

25.116  8684 

20 

22.562  9785 

23.123  6671 

24.297  3698 

25.544  6576 

26.870  3745. 

21 

23.845  0158 

24.470  5221 

25-783  3172 

27.183  2741 

28.676  4857 

22 

25-143  0785 

25-837  5799 

27.298  9835 

28.862  8559 

30.536  7803 

23 

26.457  3669 

27.225  1436 

28.844  9632 

30.584  4273 

32.452  8837 

24 

27.788  0840 

28.633  5208 

30.421  8625 

32.349  0380 

34-426  4702 

25 

29-I35  435i 

30.063  0236 

32.030  2997 

34-157  7639. 

36.459  2643 

26 

30.499  6280 

31.513  9690 

33.670  9057 

36.011  7080 

38.553  0423 

27 

31.880  8734 

32.986  6785 

35-344  3238 

37.912  0007 

40.709  6335 

28 

33.279  3843 

34-481  4787 

37.051  2103 

39.859  8007 

42.930  9225 

29 

34-695  3766 

35.998  7009 

38.792  2345 

41.856  2958 

45.218  8502 

3° 

36.129  0688 

37.538  6814 

40.568  0792 

43.902  7032 

47.5754157 

3i 

37.580  6822 

39.101  7616 

42.379  4408 

46.000  2707 

50.002  6782 

32 

39.050  4407 

40.688  2880 

44.227  0296 

48.150  2775 

52.502  7585 

33 

40.538  5712 

42.298  6123 

46.111  5702 

50.354  0344 

55.077  8413 

34 

42.045  3033 

43-933  0915 

48.033  8016 

52.612  8853 

57.730  1765 

35 

43.570  8696 

45.592  0879 

49.994  4776 

54.928  2074 

60.462  0818 

36 

45-H5  5°55 

47.275  9692 

51.994  3672 

57.301  4126 

63.275  9443 

37 

46.679  4493 

48.985  1087 

54.034  2545 

59-733  9479 

66.174  2226 

38 

48.262  9424 

50.719  8854 

56.114  9396 

62.227  2966 

69.1594493 

39 

49.866  2292 

52.480  6837 

58.237  2384 

64.782  9791 

72.234  2328 

40 

5^489  5571 

54.267  8939 

60.401  9832 

67.402  5535 

75.401  2597 

4i 

53-133  1765 

56.081  9123 

62.610  0228 

70.087  6174  . 

78.663  2975 

42 

54-797  34" 

57-923  1410 

64.862  2233 

72.839  8078 

82.023  1965 

43 

56.482  3080 

59.791  9881 

67.1594678 

75.660  8030 

85.483  8923 

44 

58.188  3369 

61.688  8679 

69.502  6571 

78.552  3231 

89.048  4091 

45 

59.915  6911 

63.614  2010 

71.892  7103 

81.516  1312 

92.719  8614 

46 

61.664  6372 

65.568  4140 

74.330  5645 

84-554  0344 

96.501  4572 

47 

63-435  4452 

67.551  9402 

76.817  1758 

87.667  8853 

100.396  5009 

48 

65.228  3884 

69.565  2193 

79-353  5193 

90.859  5824 

104.408  3960 

49 

67.043  7431 

.71.608  6976 

81.940  5897 

94.131  0720 

108.540  6479 

5° 

68.881  7899 

73.682  8280 

84-579  4015 

97.484  3288 

112.796  8673 

APPENDIX  B 

TABLE  III 
Sum  to  which  an  annuity  of  i  per  year  will  accumulate  in  n  periods 


663 


*m  — 

i 

ti% 

4% 

4*% 

5% 

6% 

n 

1  .OOO  OOOO 

I  .OOO  OOOO 

I.  OOO  OOOO 

I.  OOO  OOOO 

I.  OOO  OOOO 

I 

2.035  oooo 

2.040  oooo 

2.045  oooo 

2.050  oooo 

2.060  oooo 

2 

3.106  2250 

3.121  6000 

3.137  0250 

3.152  5000 

3.183  6000 

3 

4.214  9429 

4.246  4640 

4.278  1911 

4.310  1250 

4.374  6160 

4 

5.362  4659 

5.4163226 

5-470  7097 

5.525  6312 

5.637  0930 

5 

6.550  1522 

6.632  9755 

6.716  8917 

6.801  9128 

6.975  3185 

6 

7-779  4075 

7.898  2945 

8.019  1518 

8.142  0085 

8.393  8376 

7 

9.051  6868 

9.214  2263 

9.380  0136 

9.549  1089 

9.897  4679 

8 

10.368  4958 

10.582  7953 

10.802  1142 

11.026  5643 

11.491  3160 

9 

11-731  3932 

12.006  1071 

12.288  2094 

12.577  8925 

13.180  7949 

10 

13.141  9919 

I3-486  3514 

13.841  1788 

14.206  7872 

14.971  6426 

ii 

14.601  9616 

15.025  8055 

15.4640318 

15.917  1265 

16.869  9412 

12 

16.113  0303 

16.626  8377 

17.159  9132 

17.712  9828 

18.882  !377 

13 

17.676  9864 

18.291  9112 

18.932  0194 

19.598  6320 

21.015  0659 

14 

19.295  6809 

20.023  5876 

20.784  0543 

21.578  5636 

23.275  9699 

15 

20.971  0297 

21.824  5311 

22.719  3367 

23.657  4918 

25.672  5281 

16 

22.705  0157 

23.697  5124 

24.741  7069 

25.840  3664 

28.212  8798 

17 

24.499  6913 

25.645  4129 

26.855  0837 

28.132  3847 

30.905  6525 

18 

26.357  1805 

27.671  2294 

29.063  5625 

30.539  0039 

33-759  9917 

19 

28.279  6818 

29.778  0786 

31.371  4228 

33-065  9541 

36.785  5912 

20 

30.269  4707 

31.969  2017 

33-783  1368 

35.719  2518 

39.992  7267 

21 

32.328  9021 

34.247  9698 

36.303  3780 

38.505  2144 

43.392  2903 

22 

34.460  4137 

36.617  8886 

38.937  0300 

41.4304751 

46.995  8277 

23 

36.666  5282 

39.082  6041 

41.689  1963 

44.501  9989 

50.815  5774 

24 

38.949  8567 

41.645  9083 

44.565  2101 

47.727  0988 

54.864  5120 

25 

41.313  1017 

44.311  7446 

47.570  6446 

51.113  4538 

59.1563827 

26 

43-759  0602 

47.084  2144 

50.711  3236 

54.669  1264 

63-705  7657 

27 

46.290  6273 

49.967  5830 

53-993  3332 

58.402  5828 

68.528  1116 

28 

48.910  7993 

52.966  2863 

57.423  0332 

62.322  7119 

73-639  7983 

29 

51.622  6773 

56.084  9377 

61.007  0697 

66.438  8475 

79.058  1862 

30 

54.429  4710 

59.328  3353 

64.752  3878 

70.760  7899 

84.801  6774 

31 

57-334  5025 

62.701  4687 

68.666  2452 

75.298  8294 

90.889  7780 

32 

60.341  2IOI 

66.209  5274 

72.756  2263 

80.063  77°8 

97-343  1647 

33 

63-453  1524 

69-857  9085 

77.030  2565 

85.066  9594 

104.183  7546 

34 

66.674  0127 

73.652  2249 

81.496  6180 

90.320  3074 

111.434  7799 

35 

70.0O7  6032 

77.598  3138 

86.163  9658 

95.836  3227 

119.120  8667 

36 

73457  8693 

81.702  2464 

91.041  3443 

101.628  1389 

127.268  1187 

37 

77.028  8947 

85-970  3363 

96.138  2048 

107.709  5458 

135.904  2058 

38 

80.724  9060 

90.409  1497 

101.464  4240 

114.095  0231 

145.058  4581 

39 

84.550  2777 

95-025  5157 

107.030  3231 

120.799  7742 

154.761  9656 

40 

88.509  5375 

99.826  5363 

112.846  6876 

127.839  7630 

165.047  6836 

41 

92.607  3713 

104.819  5978 

118.924  7885 

135-231  75" 

I75-950  5446 

42 

96.848  6293 

IIO.OI2  3817 

125.276  4040 

142.993  3387 

187-507  5772 

43 

101.2383313 

II5.4I2  8770 

131.913  8422 

151.143  0056 

199.7580319 

44 

105.781  6729 

I2I.O29  392O 

138.849  9651 

159.700  1559 

212.743  5138 

45 

110.484  0314 

126.870  5677 

146.098  2135 

168.685  1637 

226.508  1246 

46 

"5-3509725 

132.945  3904 

153-672  6331 

178.119  4218 

241.098  6121 

47 

120.388  2566 

I39.263  2O6O 

161.587  9016 

188.025  3929 

256.564  5288 

48 

125.601  8456 

M5-833  7343 

169.859  3572 

198.426  6626 

272.958  4005 

49 

130.997  9102 

152.667  0837 

178.503  0283 

209.347  9957 

290.335  9046 

50 

664  PRINCIPLES  OF  ACCOUNTING 

TABLE  IV 
Present  value  of  an  annuity  of  i  per  year  for  n  periods 


On  = 

(i  +  »)" 

i 

n 

i*% 

Ij% 

3% 

2j% 

3% 

I 

0.987  6543 

0.985  2217 

0.980  3922 

0.975  6098 

0.970  8738 

2 

1.963  1154 

1-955  8834 

I.94I  5609 

1.927  4242 

I.9I3  4697 

3 

2.926  5307 

2.912  2004 

2.883  8833 

2.856  0236 

2.828  6114 

4 

3.878  0580 

3.854  3846 

3.807  7287 

3.76l  9742 

3.717  0984 

5 

4.817  8350 

4.782  6450 

4.713  4595 

4.645  8285 

4-579  7072 

6 

5.746  0099 

5.697  1872 

5.601  4309 

5.508  1254 

5.417  1914 

7 

6.662  7258 

6.598  2140 

6.471  9911 

6-349  3906 

6.230  2830 

8 

7.568  1243 

7.485  9251 

7.325  4814 

7.170  1372 

7.019  6922 

9 

8.462  3450 

8-3605173 

8.162  2367 

7.970  8655 

7.786  1089 

10 

9-345  5259 

9.222  1846 

8.982  5850 

8.752  0639 

8.530  2028 

ii 

10.217  8034 

10.071  1178 

9.786  8480 

9.514  2087 

9.252  6241 

12 

11.079  3120 

10.907  5052 

10.575  3412 

10.257  7646 

9.954  0040 

13 

11.930  1847 

11.731  5322 

11.348  3737 

10.983  1850 

10.634  9553 

14 

12.770  5527 

12.543  3815 

12.106  2488 

II.69O  9122 

11.296  0731 

IS 

13.600  5459 

13-343  233° 

12.849  2635 

12.381  3777 

H-937935I 

16 

14.420  2923 

14.131  2641 

13-577  7093 

13.055  0027 

12.561  IO2O 

i? 

15.229  9183 

14-907  6493 

14.291  8719 

13.712  1977 

I3.I66  1185 

18 

16.029  5489 

15.672  5609 

14.992  0312 

14-353  3636 

13-753  5131 

iQ 

16.819  3076 

16.426  1684 

15.678  4620 

14.978  8913 

I4.323  7991 

20 

17.599  3161 

17.168  6388 

16.351  4333 

15.589  1623 

14.877  4749 

21 

18.369  6949 

17.900  1367 

17.011  2092 

16.184  5486 

15.415  0241 

22 

19.130  5629 

18.620  8244 

17.658  0482 

16.765  4132 

15.936  9166 

23 

19.882  0374 

19.330  8614 

18.292  2041 

17.332  1105 

16.443  6084 

24 

20.624  2345 

20.030  4054 

18.913  9256 

17.884  9858 

16.935  542i 

25 

21.357  2686 

20.719  6112 

19-523  4565 

18.424  3764 

17.413  1477 

26 

22.081  2530 

21.398  6317 

20.  121  0358 

18.950  6m 

17.876  8424 

27 

22.796  2993 

22.067  6175 

2O.7O6  8978 

19.464  0109 

18.327  0315 

28 

23.502  5178 

22.726  7167 

2I.28l  2724 

19.964  8887 

18.764  1082 

29 

24.200  0176 

23-376  0756 

21.844  3847 

20.453  5499 

19.188  4546 

30 

24.888  9062 

24.015  8380 

22.396  4556 

20.930  2926 

19.600  4413 

31 

25.569  2901 

24.646  1458 

22.937  7015 

21.395  4074 

20.000  4285 

32 

26.241  2742 

25.267  1387 

23.468  3348 

21.849  1780 

20.388  7655 

33 

26.904  9621 

25.878  9544 

23.988  5636 

22.291  8809 

20.765  7918 

34 

27.560  4564 

26.481  7285 

24.498  5917 

22.723  7863 

21.131  8367 

35 

28.207  8582 

27-075  5946 

24.998  6193 

23-U5  1573 

21.487  22OI 

36 

28.847  2674 

27.660  6843 

25.488  8425 

23-556  2511 

21.832  2525 

37 

29.478  7826 

28.237  1274 

25.969  4534 

23-957  3i8i 

22.167  2354 

38 

30.102  5013 

28.805  0516 

26.440  6406 

24.348  6030 

22.492  4616 

39 

30.718  5198 

29.364  5829 

26.902  5888 

24.730  3444 

22.8o8  2151 

40 

31.326  9332 

29.915  8452 

27-355  4792 

25.102  7750 

23.114  7720 

4i 

31.9278352 

30.458  9608 

27.799  4895 

25.466  i  220 

23412  400O 

42 

32.521  3187 

30.994  0500 

28.234  7936 

25.820  6068 

23  701  3592 

43 

33.1074753 

31.521  2316 

28.661  5623 

26.166  4457 

23.981  9021 

44 

33.686  3954 

32.040  6222 

29.070  9631 

26.503  8495 

24.254  2739 

45 

34.258  1682 

32.552  3372 

29.490  1599 

26.833  0239 

24.518  7125 

46 

34.822  8822 

33.056  4898 

29.892  3136 

27.154  1696 

24-775  4491 

47 

35.380  6244 

33-553  1919 

30.286  5820 

27.467  4826 

25.024  7078 

48 

35.931  4809 

34.042  5536 

30.673  1196 

27-773  1537 

25.266  7066 

49 

36.475  5367 

34.524  6834 

31.052  0780 

28.071  3695 

25.501  6569 

5° 

37.012  8757 

34.999  6881 

31.423  6059 

28.362  3117 

25.729  7640 

APPENDIX  B 


665 


TABLE  IV 
Present  value  of  an  annuity  of  i  per  year  for  n  periods 


0.966  1836 

1.899  6943 
2.801  6370 
3-673  0792 
4-5J5  0524 
5-328  5530 
6.114  544° 
6.873  9555 
7.607  6865 
8.316  6053 
9.001  5510 
9-663  3343 
10.302  7385 
10.920  5203 

11.5174109 
12.094  1168 
12.651  3206 
13.189  6817 
13.709  8374 
14.212  4033 
14.697  9742 
15.167  1248 
15.620  4105 
16.058  3676 
16.481  5146 
16.890  3523 
17.285  3645 
17.6670188 
18.035  7670 
18.392  0454 
18.736  2758 
19.068  8655 
19.390  2082 
19.700  6842 
20.000  6611 
20.290  4938 
20.570  5254 
20.841  0874 
21.102  4999 
21.3550723 
21.599  1037 
21.834  8828 
22.062  6887 
22.282  7910 
22.495  45°3 
22.700  9181 
22.899  4378 
23.091  2443 
23-276  5645 
23-455  6i79 


4% 
0.961  5385 

1.886  0947 

2-775  °910 
3.629  8952 
4.451  8223 
5.242  1369 
6.002  0547 
6.732  7449 
7-435  33J6 
8.110  8958 
8.760  4767 
9-385  0738 
9.985  6478 
10.563  1229 
11.118  3874 
11.652  2956 
12.165  6689 
12.659  2970 
i3-J33  9394 
13-59°  3263 
14.029  1599 
14.451  1153 
14.856  8417 
15.246  9631 
15.622  0799 

15.982  7692 
16.329  5857 

16.663  0632 

16.983  7146 
17.292  0333 
17.588  4936 
I7-873  5515 
18.147  6457 
18.411  1978 

18.664  6132 
18.908  2820 
19.142  5788 
19.367  8642 
19.584  4848 
I9-792  7739 
19-993  05!8 
20.185  6267 
20.370  7949 
20.548  8413 
20.720  0397 
20.884  6536 
21.042  9361 
21.195  1309 
21.341  4720 
21.482  1846 


43% 

0.956  9378 
1.872  6678 

2.748  9644 

3.587  5257 
4.389  9767 
5.157  8725 
5.892  7009 

6.595  8861 
7.268  7905 

7.912  7181 
8.528  9169 
9.118  5808 
9.682  8524 

IO.222  8253 

10.739  5457 
11.2340150 

11.707  1914 
12.159  9918 
12.593  2936 
13-007  9365 
13.404  7239 
!3.784  4248 
14.147  7749 
14.495  4784 
14.828  2090 
15.146  6114 
15-451  3028 
!5.742  8735 
16.021  8885 
16.288  8885 
16.544 


17.022  8621 
17.246  7580 
17.461  0124 
17.666  0406 
17.862  2398 
18.049  9902 
18.229  6557 
18.401  5844 
18.566  1095 
18.723  5498 
18.874  2103 
19.018  3831 
19.156  3474 
19.288  3707 
19.414  7088 
19-535  6065 
19.651  2981 
19.762  0078 


0.952  3810 
1.859  4104 
2.723  2480 
3-545  9505 
4.329  4767 
5.075  6921 
5-786  3734 
6.463  2128 
7.107  8217 
7-721  7349 
8.306  4142 
8.863  2516 
9-393  5730 
9.898  6409 
10.379  6580 
10.837  7696 
11.274  0662 
11.689  5869 
12.085  3209 
12.462  2103 
12.821  1527 
13.163  0026 
13.488  5739 
13.798  6418 
14.093  9446 
14-375  1853 
14.643  0336 
14.898  1273 
15.141  0736 

I5-372  4510 
15.592  8105 
15.802  6767 
16.002  5492 
16.192  9040 
16.374  1943 
16.546  8517 
16.711  2873 
16.867  8927 
17.017  0407 
17.1590864 
17.294  3680 
17.423  2076 
17-545  9120 
17.662  7733 
17.774  0698 
17.8800665 
17.891  0157 
18.077  1578 
18.168  7217 
18.255  9255 


0.943  3962 

1-833  3927 
2.673  0119 
3.465  1056 
4.212  3638 

4-9x7  3243 
5.582  3814 
6.209  7938 
6.801  6923 
7.360  0870 
7.886  8746 

8.383  8439 
8.852  6830 

9.294  9839 

9.712  2490 

10.105  8953 

10.477  2597 

10.827  6035 

11.158  1165 

11.469  9212 

11.764  0766 

12.041  5817 

12.303  3790 

12.5503575 

12.783  3562 

13.003  1662 

13.210  5341 

13.406  1643 

13.590  7210 

13.764  8312 

13.929  0860 

14.084  0434 

14.230  2296 

14.368  1411 

14.498  2464 

14.620  9871 

14.736  79°3 

14.846  0192 

14.949  0747 

15.046  2969 

15.1380159 

15-224  5433 
15.306  1729 
15.383  1820 
15-455  8321 
I5-524  3699 
15.5890282 
15.650  0266 

15-707  5723 
15.761  8606 


i 

2 

3 
4 
5 
6 

7 
8 

9 
10 
ii 

12 
13 
14 
15 

16 

17 
18 

19 

20 
21 
22 
23 
24 
25 
26 

27 
28 
29 
30 
31 
32 

33 
34 
35 
36 
37 
38 
39 
40 

4i 
42 

43 
44 
45 
46 

47 
48 

49 
50 


666 


PRINCIPLES  OF  ACCOUNTING 


TABLE  V 
Sinking  fund  or  annuity  which,  invested  at  the  end  of  each  period,  will  amount 
to  i  in  n  periods 
i 

(I  +  0"-  I 

• 

il% 

ii% 

t% 

4% 

3% 

i 

1.  000  0000 

1.  000  0000 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

2 

0.496  8944 

0.496  2779 

0.495  0495 

0.493  8272 

0.492  6108 

3 

0.329  2OI2 

0.328  3830 

0.326  7547 

0.325  1372 

0-323  5304 

4 

0.245  36lO 

0.244  4448 

0.242  6237 

0.240  8179 

0.2390270 

5 

0.195  O62I 

0.194  0893 

0.192  1584 

0.190  2469 

o.i  88  3546 

6 

0.161  5338 

0.160  5252 

0.158  5258 

0.156  5500 

0.154  5975 

7 

0.137  5887 

0.136  5562 

0.134  5120 

0.132  4954 

0.130  5063 

8 

0.119  6331 

0.118  5840 

0.116  5098 

0.1144673 

o.i  1  2  4564 

9 

0.105  6705 

0.104  6098 

0.102  5154 

o.ioo  4569 

0.098  4339 

10 

0.094  5031 

0.093  4342 

0.091  3265 

0.089  2588 

0.087  2305 

ii 

0.085  3684 

0.084  2938 

0.082  1779 

0.080  1060 

0.078  0774 

12 

0.077  7583 

0.076  6800 

0.074  5596 

0.072  4871 

0.070  4621 

13 

0.071  3210 

0.070  2404 

0.068  1183 

0.066  0483 

0.064  0295 

14 

0.065  8051 

0.064  7233 

0.062  6020 

0.060  5365 

0.058  5263 

IS 

0.061  0265 

0.059  9444 

0.057  8255 

0.055  7665 

0.053  7666 

16 

0.056  8467 

0-055  7651 

0.053  6501 

0.051  5990 

0.049  6108 

J7 

0.053  1602 

0.052  0797 

0.049  9698 

0.047  9278 

0.045  9525 

18 

0.049  8848 

0.048  8058 

0.046  7021 

0.044  6701 

0.042  7087 

19 

0.046  9555 

0.045  8785 

0.043  7818 

0.041  7606 

0.039  8139 

20 

0.044  3204 

0.043  2457 

0.041  1567 

0.039  1471 

0.037  2157 

21 

0.041  9375 

0.040  8655 

0.038  7848 

0.036  7873 

0.034  8718 

22 

0.039  7724 

0.038  7033 

0.036  6314 

0.034  6466 

0.032  7474 

23 

0.037  7967 

0.036  7307 

0.034  6681 

0.032  6964 

0.030  8139 

24 

0.035  9866 

0.034  9241 

0.032  8711 

0.030  9128 

0.029  °474 

25 

0.034  3225 

0.033  2634 

0.031  2204 

0.029  2759 

0.027  4279 

26 

0.032  7873 

0.031  7320 

0.029  6992 

0.027  7687 

0.025  9383 

27 

0.031  3668 

0.030  3153 

0.028  2931 

0.026  3769 

0.024  5642 

28 

0.030  0486 

0.029  o011 

0.026  9897 

0.025  0879 

0.023  2932 

29 

0.028  8223 

0.027  7788 

0.025  7784 

0.023  8913 

O.O22  1147 

30 

0.027  6785 

0.026  6392 

0.024  6499 

O.O22  7776 

0.021  0193 

31 

0.026  6094 

0.025  5743 

0.023  5963 

0.021  7390 

O.OI9  9989 

32 

0.025  6079 

0.024  577i 

O.O22  6lo6 

O.O2O  7683 

O.OI9  0466 

33 

0.024  6679 

0.023  6414 

O.O2I  6865 

0.019  8594 

O.OlS  1561 

34 

0.023  7839 

O.022  7619 

O.O20  8187 

O.OI9  0067 

0.017  3220 

35 

O.O22  9511 

0.021  9336 

O.O20  OO22 

O.OlS  2056 

0.016  5393 

36 

O.O22  1653 

O.O2I  1524 

O.OI9  2328 

0.017  4516 

0.015  8038 

37 

O.O2I  4227 

O.O2O  4144 

O.OlS  5068 

0.016  7409 

0.015  1116 

38 

O.O2O  7198 

0.019  7T6i 

O.OI7  8206 

0.016  0701 

0.014  4593 

39 

O.02O  0536 

0.019  0546 

O.OI7  I7II 

0.015  4361 

0.013  8438 

40 

0.019  42I4 

0.018  4271 

0.016  5557 

0.014  8362 

0.013  2624 

4i 

O.OlS  82O6 

0.017  8311 

0.015  9719 

0.014  2679 

O.OI2  7124 

42 

O.OlS  2491 

0.017  2643 

0.015  4173 

0.013  7288 

O.OI2  1917 

43 

0.017  7047 

0.016  7246 

0.014  8899 

0.013  2169 

o.on  6981 

44 

O.OI7  1856 

0.016  2104 

0.014  3879 

0.012  7304 

o.on  2298 

45 

0.016  6901 

0.015  7198 

0.013  9096 

O.OI2  2675 

o.oio  7852 

46 

c.oi6  2167 

0.015  2512 

0.013  4534 

o.on  8268 

o.oio  3625 

47 

0.015  7641 

0.014  8034 

0.013  OI79 

o.on  4067 

0.009  9605 

48 

0.015  3307 

0.014  3750 

0.012  6018 

o.on  0060 

0.009  5778 

49 

0.014  9X56 

0.013  9648 

O.OI2  2040 

o.oro  6235 

0.009  2131 

5° 

0.014  5176 

0.013  5717 

o.on  8232 

o.oio  2581 

0.008  8655 

APPENDIX  B 


667 


TABLE  V 

Sinking  fund  or  annuity  which,  invested  at  the  end  of  each  period,  will 
amount  to  i  in  n  periods 


T  =  — 
(i  +»)"-  I 

3i% 

4% 

4i% 

5% 

6% 

n 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

I.OOO  OOOO 

I 

0.491  4005 

0.490  1961 

0.488  9976 

0.487  8049 

0.485  4369 

2 

0.321  9342 

0.320  3485 

0.318  7734 

0.317  2086 

0.314  1098 

3 

0.237  2511 

0.235  4900 

0.233  7436 

0.232  0118 

0.228  5915 

4 

0.186  4814 

0.184  6271 

0.182  7916 

0.180  9748 

0.177  3964 

5 

0.152  6682 

0.150  7619 

0.148  8784 

0.1470175 

0.143  3626 

6 

0.128  5445 

0.126  6096 

0.124  7015 

O.I22  8198 

0.119  1350 

7 

o.no  4766 

0.108  5278 

0.106  6096 

0.104  7218 

o.ioi  0359 

8 

0.096  4460 

0.094  4930 

0.092  5745 

0.090  6901 

0.087  0222 

9 

0.085  2414 

0.083  2909 

0.081  3788 

0.079  5°46 

O.075  868O 

10 

0.076  0920 

0.074  X49° 

0.072  2482 

0.070  3889 

O.O66  7929 

ii 

0.068  4839 

0.066  5522 

0.064  6662 

0.062  8254 

0.059  2770 

12 

0.062  0616 

0.060  1437 

0.058  2753 

0.056  4558 

O.O52  9601 

13 

0.056  5707 

0.054  6690 

0.052  8203 

0.051  0240 

0.047  5849 

14 

0.051  8251 

0.049  94  ir 

0.048  1138 

0.046  3423 

0.042  9628 

15 

0.047  6848 

0.045  8200 

0.044  0154 

0.042  2699 

0.038  9521 

16 

0.044  0431 

0.042  1985 

0.040  4176 

0.038  6991 

0.035  4448 

17 

0.040  8168 

0.038  9933 

0.037  2369 

0.035  5462 

0.032  3565 

18 

0.037  9403 

0.036  1386 

0.034  4073 

0.032  7450 

O.O29  6209 

19 

0.035  3611 

0.033  5817 

0.031  8761 

0.030  2426 

O.027  1846 

20 

^•033  0366 

0.031  2801 

0.029  6006 

0.027  9961 

O.O25  °°45 

21 

0.030  9321 

0.029  *988 

0.027  5456 

0.025  9705 

O.O23  0456 

22 

0.029  0188 

0.027  3091 

0.025  6825 

0.024  X368 

0.021  2785 

23 

0.027  2728 

0.025  5868 

0.023  9870 

0.022  4709 

O.Oig  6790 

24 

0.025  6740 

0.024  0120 

O.O22  4390 

0.020  9525 

O.OlS  2267 

25 

0.024  2054 

O.O22  5674 

O.O2I  O2I4 

0.019  5643 

0.016  9043 

26 

O.O22  8524 

O.O2I  2385 

0.019  7195 

0.018  2919 

0.015  6972 

27 

O.O2I  6026 

O.O2O  OI3O 

O.OlS  52O8 

0.017  1225 

0.014  5925 

28 

0.020  4454 

O.OlS  8799 

O.OI7  4146 

0.016  0455 

0.013  5796 

29 

0.019  3713 

O.OI7  8301 

0.016  3915 

0.015  0514 

O.OI2  6489 

30 

0.018  3724 

0.016  8553 

0.015  4434 

0.014  1321 

o.ou  7922 

31 

0.0174415 

0.015  9486 

0.014  5632 

0.013  2804 

o.ou  0023 

32 

0.016  5724 

0.015  1036 

0.013  7445 

O.OI2  4900 

o.oio  2729 

33 

0.015  7597 

0.014  3X48 

0.012  9819 

o.ou  7554 

0.009  5984 

34 

0.014  9983 

0.013  5773 

O.OI2  2704 

o.ou  0717 

0.008  9739 

35 

0.014  2842 

O.OI2  8869 

o.ou  6058 

o.oio  4345 

0.008  3948 

36 

0.013  6132 

O.OI2  2396 

o.oio  9840 

0.009  8398 

0.007  8574 

37 

O.OI2  9821 

o.ou  6319 

o.oio  4017 

0.009  2842 

0.007  358i 

38 

0.012  3877 

o.ou  0608 

0.009  8557 

0.008  7646 

0.006  8938 

39 

o.ou  8273 

o.oio  5235 

0.009  3431 

0.008  2782 

0.006  4615 

40 

o.ou  2982 

o.oio  0174 

0.008  8616 

0.007  8223 

0.006  0589 

41 

o.oio  7983 

0.009  5402 

0.008  4087 

0.007  3947 

0.005  6834 

42 

o.oio  3254 

0.009  0899 

0.007  9823 

0.006  9933 

0.005  3331 

43 

0.009  8777 

0.008  6645 

0.007  5807 

0.006  6162 

0.005  0061 

44 

0.009  4534 

0.008  2625 

0.007  2O20 

0.006  2617 

0.004  7005 

45 

0.009  0511 

0.007  8820 

0.006  8447 

0.005  9282 

0.004  4T48 

46 

0.008  6692 

0.007  5219 

0.006  5073 

0.005  6142 

0.004  H77 

47 

0.008  3065 

0.007  !8o6 

0.006  1886 

0.005  3184 

0.003  8977 

48 

0.007  9617 

0.006  8571 

0.005  8872 

0.005  0396 

0.003  6636 

49 

0.007  6337 

0.006  5502 

0.005  6021 

0.004  7767 

0.003  4443 

So 

RAILWAY  STATEMENTS 


INCOME  STATEMENT 
Of  the  X  Railroad  Company 

For  the  year  ended  December  aist,  1915 

Operating  Income : 

'Freight $140,654,856 

Passenger       38,611,085 

Mail 3,372,458 

Express 4,204,727 

lg  I  All  other  transportation  .     .  3,806,402 

Incidental 6,203,637 

Joint  facility  —  Credit     .    .  8,998 

Joint  facility  —  Debit  .     .     .    233,996 

Total $196,628,167 

Maintenance  of  way  and  struc- 
tures        $25,328,512 

Railway          Maintenance  of  equipment  .  38,641,078 

Operating'  Traffic       2,386,064 

Expenses     Transportation        ....  68,650,005 

Miscellaneous 2,653,146 

.General 5,077,754 

Total 142,736,559 

Net  Revenue  from  Railway  Operations  $53,891,608 

Railway  Tax  Accruals $7,594,403 

Uncollectible  Railway  Revenues        .    .    .  46,280 

7,640,683 
Railway  Operating  Income $46,250,925 

Revenues  from  Miscellaneous  Operations  $342,650 

Expenses  of  Miscellaneous  Operations    .     .  216,420 

Net  Revenue  from  Miscellaneous  Operations  126,230 

Total  Operating  Income $46,377,155 

668 


APPENDIX  C 


669 


Non-Operat- 
ing Income 


Joint  facility  rent  income      .  $  1,511,004 

Income  from  lease  of  road    .  173,786 

Miscellaneous  rent  income    .  829,881 

Miscellaneous  non-operating 

physical  property     .     .     .  75,395 

Dividend  income     ....  13,334,499 

Income  from  funded  securities  790,395 

Income  from  unfunded  se- 
curities arid  accounts    .     .  2,255,459 

Income    from    sinking    and 

other  reserve  funds  .     .     .  1,307,888 

Release    of    premiums    on 

funded  debt 3,936 

Miscellaneous  income  .     .     .  93,072 
Total  non-operating  income 


Gross  Income 


20,375,315 
$66,752,470 


Deductions 
from    Gross 
Income 


Hire  of  equipment  —  debit 

balance       $  1,325,955 

Joint  facility  rents  .  .  .  1,084,556 
Rent  for  leased  roads  .  .  8,574,859 
Miscellaneous  rents  .  .  .  711,049 
Miscellaneous  tax  accruals  .  41, 943 
Separately  operated  proper- 
ties—  loss 33,7i7 

Interest  on  funded  debt   .     .  11,834,384 

Interest  on  unfunded  debt  287,906 
Amortization  of  discount  on 

funded  debt 3 5, 400 

Miscellaneous  income 

charges       306, 549 


Total  deductions  from  gross  income 


Net  Income 


24,236,318 
$42,516,152 


Disposition  of  Net  Income : 
Income  applied  to  sinking  fund  and  other 

reserve  funds $  1,946,341 

Dividend  appropriations  of  income    .     .     .        29,552,219 
Income    appropriated    for   investment    in 

physical  property : 

Expended  for  revision  of  grades,  align- 
ment, and  tracks,  elimination  of  grade 
crossings,  betterment  of  equipment, 
water  supply,  etc 7,286,849 


6yo 


PRINCIPLES  OF  ACCOUNTING 


Construction  expenditures  on  leased  and 
branch  roads  directly  operated,  borne 
by  the  X  Railroad  Company .  .  .  .  $3,239,912 

Stock  discount  extinguished  through  income  .         200,000 

42,225,321 

Balance  transferred  to  credit  of  Profit  and 

Loss $290,831 

PROFIT  AND  Loss  STATEMENT 

Amount  to  credit  of  Profit  and  Loss  December 

31,  IQI4 $31,751,125 

Credit  balance  transferred  from  income     .     .  290,831 

Profit  on  road  and  equipment  sold    ....  8,600 

Delayed  income  credits 12,200 

Unrefundable  overcharges 650 

Donations 26,500 

$32,089,906 
Deduct : 
Surplus  applied  to  sinking  and  other  reserve 

funds $1,522,000 

Dividend  appropriations  of  surplus  ....  626,000 

Debt  discount  extinguished  through  surplus  .  484,680 

Miscellaneous  appropriations  of  surplus     .     .  142,000 

Loss  on  retired  road  and  equipment      .     .     .  716,450 

Delayed  income  debits 37,798 

3,528,928 
Balance  to  credit  of  Profit  and  Loss  December  3ist,  1915  $28,560,978 

GENERAL  BALANCE  SHEET  OF  THE  X  RAILROAD  COMPANY 
December  31,  1915 

Assets 

Investments : 
Investment  in  Road  and  Equipment : 

Road $306,815,457 

Equipment 188,972,593 

General  expenditures 68,152 


Improvement  on  Leased  Railway  Property 
since  June  3oth,  1907  : 

Leased  lines  road $18,125,575 

Leased  lines  equipment 160,670 

Leased  lines  general  expenditures  .    .     .      1,288 


$495,856,202 


18,287,533 


APPENDIX  C 


671 


Sinking  funds $3,469,022 

Less  X  R.R.  Co.  obligations       1,391,100  2,077,922 

Miscellaneous  physical  property    .     .     .     '. 2,132,020 

Investments  in  affiliated  companies : 

Stocks         $164,784,523 

Bonds 31,712,865 

Notes 75,522,918 

Advances 12,611,467 

284,631,773 

Other  investments : 

Stocks $65,412,599 

Bonds 538,946 

Notes 15.745 

Miscellaneous 12        65,967,302 

Current  Assets : 

Cash $13,778,292 

Time  drafts  and  deposits 28,004,263 

Special  deposits 336,916 

Loans  and  bills  receivable 50,406 

Traffic  and  car-service  balances  receivable  .  16,732,166 
Net  balance  receivable  from  agents  and 

conductors 6,490,728 

Miscellaneous  accounts  receivable      .     .     .  9,122,087 

Material  and  supplies 16,989,418 

Interest  and  dividends  receivable       .     .     .  1,695,642 

Rents  receivable 56,081 

Deferred  Assets :  93>255,999 

Working  fund  advances $       193,291 

Insurance  and  other  funds    .         $34,291,172 
Less  X  R.R.  Co.  obligations  4,028,500 

30,262,672 

Other  deferred  assets 34,345 

30,490,308 
Unadjusted  Debits : 
Rents  and   insurance  premiums   paid    in 

advance $      78,163 

Discount  on  capital  stock 8,217,600 

Discount  on  funded  debt 1,113,267 

Property  abandoned  chargeable  to  operat- 
ing expenses        139,846 

Other  unadjusted  debits 2,241,464 

Securities  issued  or  assumed  held  in 

treasury $62,250  11,790,340 

Total $1,004,489,399 


672 


PRINCIPLES  OF  ACCOUNTING 


Liabilities 

Stock: 

Capital  stock $509,265,700 

Less  —  Held  by  X.  R.R.  Co.     .     .      $32,350 
Held  for  acquisition  of  stock 
of    acquired    and     affil- 
iated companies    ....    29,650 

62,000    $509,203,700 

Premium    realized    on    capital    Stock   from 

January  ist,  1909 5,717,647 

Governmental  Grants : 

Grants  in  aid  of  construction 516,000 

Mortgage,  Bonded  and  Secured  Debt : 
Funded  Debt  of  the  X  R.R.  Co. 
Consolidated  mortgage  dollar  bonds,  5%,  due 

September  ist,  1919 $  4,998,000 

Consolidated  mortgage  dollar  bonds,  4%,  due 

May  ist,  1943 2,561,000 

Consolidated  mortgage  sterling  bonds,  3?%, 

due  July  ist,  1945 3,326,130 

Consolidated  mortgage  sterling  bonds,  4%, 

due  May  ist,  1948 19,400,000 

Ten-year  convertible  gold  bonds,  4%,  due 

May  ist,  1920      .     .     .      $20,000,000 
Less  —  Held  in  sinking  or  other 

funds 6,000        19,994,000 

Consolidated  mortgage  gold  bonds,  45%,  due 

August  ist,  1960       49,000,000 

General  mortgage  gold  bonds,  4!%,  Series 

"A,"  due  June  i,  1965        $65,000,000 
Less  —  Held  in  sinking  or  other 

funds 625,000        64,375,000 

Real  estate  purchase  money  bonds,  4%,  due 

May  ist,  1923 2,000,000 

165,654,13° 

Funded   Debt   of  Acquired   Companies 

Assumed  by  the  X  R.R.  Co. 
Orchard  Valley  Ry.   Co.  general  mtg.  4% 
gold   bonds,  due  March   ist,   1942 

$20,000,000 

Less  —  Held    in  sinking  or 

other  funds       .     .     .  870,000    $  19,130,000 

Cambwin  and   Clearfield  Ry.   Co.,   general 
mortgage    4%    coupon    registered 


APPENDIX  C 


6/3 


bonds,     due    February     ist,    1955 

$2,000,000 

Less  —  Held  in  sinking  or  other 

funds 1,460,000 

Washington    and   Jefferson    Ry.    Co.,    first 
mortgage,  6%  bonds,  due  Jan.  ist, 

1927 

Junction  R.R.   Co.   general  mortgage,  35% 

bonds,  due  April  ist,  1930    $725,000 
Less  — Held    by    X    R.R. 

Co 143,000 

Urban  and  North  Western  R.R.   Co.  gen. 

mtg-    5%    bonds,    due    Jan.    ist, 

1930    .     

Lawrence  and  Erie  R.R.  Co.  general  mortgage 

6%    bonds,    due    July    ist,    1920 

$8,680,000 

Less  —  Held   in    sinking  or 

other  funds  ....  500,000 

Pittsburgh   and    Charleston   Ry.    Co.,    first 

mtg.  4%  bonds,  due  Nov.  i,  1943 
Sunbury  and  Wabash  Ry.  Co.,  second  mtg. 

6%  bonds,  due  May  ist,  1938     .     . 
Western    Ry.    Co.    consolidated    mtg.    4% 

bonds,  due  June  ist,  1928  .... 
Guaranteed  Stock  Trust  Certificates : 
Harrisville  R.R.  4%  stock  trust  ctfs.,  due 

July  ist,  1921 

New  York  and  Vineyard  R.R.   4%   stock 

trust    ctfs.,    due   June    ist,    1948 
.     .     .  $7,478,250 


Less  —  Held  by  X 

R.R.        Co.  $        250 
Held       in 
sinking 
fund    or 

other  funds  200,000  200,250 

Equipment  trust  obligations  $17,743,016 

Less  —  Held  in  sinking  or 

other  funds  .     .     .  160,000 

Mortgages  and  ground-rents 

payable  $3,196,359 

Less  —  Held    in    sinking    or 

other  funds       .     .  883,200 


540,000 
2,073,000 

582,000 
1,021,000 

8,180,000 
18,005,000 
1,349,500 
5,536,600        56,417,100 

$6,770,000 


7,278,000        14,048,000 
17,583,016 

2,313,159 


2X 


"74 


PRINCIPLES  OF  ACCOUNTING 


Current  Liabilities : 

Loans  and  bills  payable $  3,009,000 

Traffic  and  car-service  balances  payable    .     .  14,380,033 

Audited  accounts  and  wages  payable    .     .     .  18,561,804 

Miscellaneous  accounts  payable 8,678,051 

Interest  matured  unpaid 807,955 

Dividends  matured  unpaid 58,565 

Funded  debt  matured  unpaid       1,609,440 

Unmatured  interest  accrued 2,116,066 

Unmatured  rents  accrued 267,371 

49,488,285 

Deferred  Liabilities 224,377 

Unadjusted  Credits : 

Tax  liability $  6,266,370 

Premium  on  funded  debt 191,446 

Operating  reserves 1,866,496 

Accrued  depreciation  —  road 7>592 

Accrued  depreciation  —  equipment  ....  20,036,904 

Other  unadjusted  credits 3,142,085        31,510,893 

Corporate  Surplus : 
Additions  to  property  through  income  and 

surplus  since  June  3oth,  1007      .     .     .  $83,631,500 
Funded  debt  retired  through  income  and  sur- 
plus 1,372,832 

Sinking  fund  reserves 3,467,049 

Miscellaneous  fund  reserves 34, 593, 720 

Appropriated  surplus  not  specifically  invested  187,013 

Total  appropriated  surplus 123,252,114 

Profit  and  Loss  —  Balance 28,560,978 

Total         $1,004,489,399 


D 

SELECTED  BIBLIOGRAPHY  l 
ELEMENTARY  BOOKKEEPING  AND  ACCOUNTING 

(The  student  especially  interested  in  the  study  of  elementary  accounting 
principles  and  the  details  of  bookkeeping  and  office  methods  will  find  any 
of  the  following  books  fairly  satisfactory  texts.) 

Baker,  2oth  Century  Bookkeeping  and  Accounting. 

Bogle,  Everyday  Bookkeeping. 

Kester,  Accounting  —  Theory  and  Practice.     Vol.  I. 

Klein,  Bookkeeping  and  Accounting. 

Lyons,  Accounting  —  Complete  Series. 

Miner  and  El  well,  Principles  of  Bookkeeping. 

PRINCIPLES  OF  ACCOUNTING 

(The  following  list  includes  some  of  the  more  important  books  which 
attempt  to  present  the  general  principles  of  accounting  and  the  funda- 
mentals of  the  double-entry  system.) 

Bentley,  Science  of  Accounts. 

Cole,  Accounts,  Their  Construction  and  Interpretation. 

Dickinson,  Accounting  —  Practice  and  Procedure. 

Esquerre,  Applied  Theory  of  Accounts. 

Oilman,  Principles  of  Accounting. 

Hatfield,  Modern  Accounting. 

Mitchell,  Accounting  Principles. 

Racine,  Accounting  Principles. 

Sprague,  The  Philosophy  of  Accounts. 

Wildman,  Principles  of  Accounting. 

CORPORATION  ACCOUNTING  AND  FINANCE 

Bentley,  Corporation  Finance  and  Accounting. 
Bcnnet,  Corporation  Accounting. 
Lyon,  Capitalization. 

1  This  list  of  books  is  not  intended  to  be  at  all  exhaustive,  but  it  includes  repre- 
sentative titles  under  each  of  the  various  heads  given. 

675 


676  PRINCIPLES  OF  ACCOUNTING 


INVESTMENT  MATHEMATICS  AND  ACCOUNTING 

Sprague  and  Perrine,  The  Accountancy  of  Investment. 
Skinner,  The  Mathematics  of  Investment. 


DEPRECIATION  AND  VALUATION 

Dicksee,  Depreciation,  Reserves  and  Reserve  Funds. 

Dicksee  and  Tillyard,  Goodwill  and  its  Treatment  in  the  Accounts. 

Leake,  Depreciation  and  Wasting  Assets. 

Saliers,  Principles  of  Depreciation. 

COST  ACCOUNTING 

Church,  Manufacturing  Costs  and  Accounts. 
Evans,  Cost  Keeping  and  Scientific  Management. 
Nicholson,  Cost  Accounting  —  Theory  and  Practice. 
Rovve,  Cost  Accounting  for  Manufacturing. 
Scovell,  Cost  Accounting  and  Burden  Application. 
Webner,  Factory  Accounting. 

PUBLIC  SERVICE  AND  MUNICIPAL  ACCOUNTING  AND  VALUATION 

Adams,  American  Railway  Accounting. 

Bureau  of  Municipal  Research,  New  York  City,  A  Handbook  of  Municipal 

Accounting. 

Cleveland,  Municipal  Administration  and  Accounting. 
Eggleston,  Municipal  Accounting. 
Floy,  Valuation  of  Public  Properties. 

Hayes,  Public  Utilities  —  Their  Cost  New  and  Depreciation. 
May,  Street  Railway  Accounting. 

AUDITING 

De  Paula,  The  Principles  of  Auditing. 
Montgomery,  A  itditing  Theory  and  Practice. 
Walton  and  Kimball,  Auditing  and  Cost-Finding. 


INDEX 


Account  (see  also  "Accounts"). 

balance,  153. 

balancing  an,  157,  158,  159. 

form  of,  25-27. 

Accounts  (see  also  "Assets,"  "Liabilities," 
"  Proprietorship  ") . 

classification  of,  50-55,  117,  139. 

closing,  151-159. 

controlling,  63,  82-84,  97. 

construction  of,  1 24-1 29. 

current  asset,  35-39. 

current  liability,  47,  147-150. 

current  tangible  asset,  120-126. 

expense  and  revenue,  39-43,  136-142. 

fixed  equity,  132. 

fixed  tangible  asset,  110-117. 

mixed,  52. 

payable,  313-316. 

personal,  32,  45. 

receivable  account,  126-127. 
closing  of,  174-177. 

receivable, 
valuation  of,  471-473. 

special  equity,  42-47. 

with  current  rights,  126-131. 
Accounting, 

cost,  13,  609-619. 

definition,  3. 

fiduciary,  421-425. 

function  of,  4,  7,  10. 

municipal,  620-628. 

partnership,  260-268. 

period,  155. 

railroad,  629-641. 

relation  to  the  price  system,  8. 

unit  of  organization  in,  3,  17. 
Accountancy  (see  "Accounting,"  "Auditing  ") . 
Accruals, 

of  interest,  188-189. 

of  rent,  180-181. 

of  taxes,  190,  200. 

of  wages,  178-179. 
Accrued  liabilities,  318-319. 
Accumulation   (see  also   "Discount,"   "In- 
terest"). 

of  an  annuity,  360-365. 


Accumulation  —  continued 

of  bond  discount,  381-383,  401-405. 

of  principal,  340-355. 
Adams,  H.  C.,  635. 
Adjusted  trial  balance,  219. 
Administrative  expense, 

in  income  sheet,  560,  567. 
Advertising, 

illustrative  entries,  130. 

preliminary,     535      (see     "Organization, 

costs"). 
Allocation  of  costs,  166-167  (see  a^s°  "Cost 

accounting"). 
Allowance  (see  also  "Valuation  accounts"). 

for  depreciation,  48,  107,  495. 

for  uncollectible  accounts,  127. 
Allowances  (see  also  "Discounts"). 

purchase  and  sale,  165. 
American  Society  of  Civil  Engineers, 

report  of  its  committee  on  public  utility 

valuation,  517. 

American  Telephone  and  Telegraph  Com- 
pany, 

balance  sheets  of,  597-598. 
Amortization  (see  also  "Bonds"). 

of  bond  premium,  381-383,  405-409. 

of  goodwill,  535. 

of  a  lease,  540-541. 
Annuity, 

installments,  determination  of,  373~374- 

method  of  measuring  depreciation,   525- 
526. 

payments,  apportionment  of,  376-377- 

which    a    principal    will    purchase,    374- 

376. 
Annuities,  327. 

accumulation  of,  360-365. 

entries  and  transactions  involving,  391- 

395- 

present  worth  of,  365-372. 
Appraisal,  154,  156. 
Appreciation  (see  also  "Valuation"). 

and  depreciation,  238-243. 

an  unwarranted  estimate,  465. 

as  a  basis  for  dividends,  467. 

as  unrealized  profit,  464. 

objections  to  the  recognition  of,  463-469. 


677 


INDEX 


Appropriations  (see  also  "Surplus"). 
of  surplus,  201,  300-312. 


definition  of,  18. 

Assets  (see  also  "Accounts,"  "Property"). 
accounting  for  fixed  tangible,  103-1  10. 
accounting  for  current  tangible,  1  20-1  26. 
as  a  class  of  accounting  data,  18. 
current,  36. 

current  rights  as,  126-130. 
distinction    between    foxed    and    current, 

III-II2. 

fixed,  36. 

fixed  intangible,  no,  113-116. 
Audit,  642. 

purposes  of,  642-645. 
Auditing,  642-649. 

essentials  of,  646-649. 
Auditor, 

qualifications  of  an,  647-649. 
Authorized  stock,  283. 

B 

Bad  debts  (see  also  "Accounts  receivable"). 

treatment  of,  175-176. 
Balance  (see  "Account,  balance"). 
"Balance  of  balances,"  202. 
Balance  sheet,  10,  20,  572-586. 

capital  account,  580,  581,  582. 

captions,  572-576. 

classification  of  current  assets  in,  574. 

classification  of  equities  in,  575. 

classification  of  fixed  assets  in,  573-574. 

comparative,  207,  587-592. 

condensed,  205-206. 

consolidated,  592-598. 

current  account,  580,  581,  582. 

essential  nature  of,  201-207. 

general,  572-586. 

importance  of,  201. 

in  account  form,  202. 

in  report  form,  203-204. 

municipal,  621-623. 

railway,  637,  670,  674. 
Balance  sheets, 

illustrative,  576-584. 
Bibliography, 

selected,  675,  676. 
Bond  interest,  378. 
Bond  interest  account, 

closing  of,  187. 

Bonds  (see  also  "Interest,"  "Accumulation," 
"Amortization"). 

accumulation    of    discount    on,    381-383. 
401-405. 

amortization    of    premium    on,    381-383, 
405-409. 

as  assets.  113,  115. 


Bonds  —  continued 

collateral,  325. 

convertible,  325. 

coupon,  322. 

debenture,  324-325. 

discounts  on,  379. 

equipment,  325. 

income,  324. 

interest  on,  34*-343- 

issued  at  a  discount,  401-405. 

issued  at  a  premium,  405-409. 

issued  at  par,  395-400. 

mortgage,  324. 

par  of,  378. 

payable  account,  135-136. 

premium  on,  379. 

registered,  322. 

serial,  325. 

treasury,  327. 

valuation  of,  378-380. 
Bondholder  (see  also  "Bonds"). 

control  of,  275. 

Bookkeeping  (see  also  "Accounting,"  "Ac- 
count," "Credit,"  "Debit,"  "Tech- 
nique"). 

double-entry,  basis  of,  31. 

essential  steps  in,  59. 

single-entry,  31,  255. 
Books  (see  also  "Technique"). 

principal,  56-59. 
Budget  (see  also  "Municipal  accounting"). 

municipal,  626-628. 
Buildings  (see  also  "Fixed  assets"). 

account,  closing  the,  157-158. 

in  municipal  balance  sheet,  622. 

valuation  of,  477-478. 
Business, 

enterprise,  3. 

cycle,  9. 
Buying  expense  account, 

use  of,  1 86. 


Capital  (see  also  "Proprietorship"). 

fixed  and  circulating,  37. 
Capital  deficit,  294-297. 
Capital  stock  (see  also    "Equities,"   "Pro- 
prietorship," "Stock"). 

account,  133. 

illustrative  entries  in,  134-135. 

authorized,  280,  283. 

common,  272. 

dividends,  303-305- 

donated,  285-288. 

fully  paid,  286. 

individual  accounts  for,  292. 

issued  for  cash,  280-285. 

outstanding,  284. 


INDEX 


679 


Capital  stock  —  continued 
par  value,  282. 
preferred,  273. 
subscribed,  281. 
subscriptions,  281. 
treasury,  287-290. 
unissued,  283,  284. 
Capital  surplus,  294-297. 
Cash,  123-126. 
account,  123. 

as  an  account  receivable,  125. 
book,  61,  85,  90. 
discounts,  653-656. 
as  entered  in  cash  book,  88-89. 
transactions  involving,  71-72. 
sales,  91. 

statement,  224-228,  624. 
valuation  of,  470-471. 
Certificate, 
book,  293. 
stock,  271. 
Charging  (see  also  "Debit"). 

meaning  of  term,  60. 
Closing,  151-191. 
Cole,  W.  M.,  47,  653. 
Comparative, 

balance  sheet,  207,  587-592. 
income  sheet,  555-558. 
Commercial  interest  (see  also  "Interest"). 

account,  closing  of,  188-189. 
Common  stock,  272. 

Compound   discount    (see  "Interest,"  "Dis- 
count"). 

Compound  interest  (see  also  "Interest"), 
method,  of  measuring  depreciation,    517- 

520 

Consolidated, 
balance  sheet,  592-598. 
income  sheet,  567-570. 
Construction  (see  also  "Organization"), 
period  of,  446-448. 
valuation  during,  433-450. 
Contingencies, 

treatment  by  auditor,  647. 
Contingent  liabilities,  129,  320-321. 
Contingent  reserves,  309,  310. 
Continuous  inventory,  156. 
Copartnership  (see  "Partnership"). 
Copyrights,  116,  234,  529,  539. 
Controlling  accounts,  63,  74,  97. 

advantages  of,  82-84. 
Corporate  entity,  6. 
Corporation,  4,  5-6  (see  also  "Capital  stock," 

"Bonds,"  Proprietorship"), 
importance  of,  269. 
limited  liability  of  the,  270. 
membership  of  the,  270-272. 
opening  entries  for  the,  279-280. 


Corporation  —  continued 

organization  of  a,  270. 
Cost  (see  also  "Expense,"  "Valuation"). 

accounting,  13,  600-619. 

as  a  basis  for  valuation,  451. 

of  goods  sold  account,  166. 

of    production,    relation    to    net    revenue, 
222-223. 

of  replacement,  456. 

per  job  or  order,  611. 

per  product,  610. 

per  process,  612. 

use  of  weighted  average,  476. 
^Current  assets,  120-130. 

accounts  with,  35-39. 

valuation  of,  455-456. 
Current  liabilities,  147-150. 

accounts  with,  47. 

Customers'  accounts  (see  also  "Accounts  re- 
ceivable"). 

special  methods  for  handling,  98-102, 
Customers'  ledger,  64  (see  also  "Customers' 

accounts"). 
Credit, 

denned,  31. 
Creditors'  ledger,  63. 

D 

Daybook,  57. 

Debenture  bonds,  324-325. 

Debit, 

denned,  31. 
Debit  and  credit, 

rule  for,  34. 
Defalcations,  648. 
Deferred, 

charges,  228-231,  577. 

credits,  231-232,  575. 

expense,  228-229. 

liabilities,  320. 
Deficiency, 

account,  603,  604. 

statement,  603-605. 
Deficit  (see  also  "Surplus"). 

account,  46. 

accumulated,  298. 
Departmental, 

expense  accounts,  130-141,  559-560. 

property  accounts,  117-118. 

revenue  accounts,  141-142,  561. 
depreciation,  106,  238  (see  also  "Valuation"). 

account  policy,  491-496. 

accounts,  482-505. 

allowance  for,  48,  107,  495. 

annuity  method  of  measuring,  525-526. 

compound  interest  method  of  measuring, 
517-520. 

during  construction,  436-438. 


68o 


INDEX 


Depreciation  —  continued 

entries  showing,  109. 

equal  annual  payment  method  of  measur- 
ing, Sio. 

expense  accounts,  136. 

fixed  percentage  of  declining  value  method 
of  measuring,  526-527. 

fund,  406-500. 

fund  reinvested,  503-505. 

funds  returned,  500-503. 

I.  C.  C.  rulings  in  connection  with,  634. 

methods  of  measuring,  506-527. 

physical  efficiency  as  a  basis  for  measuring, 
506-500. 

present  opinion  concerning,  454. 

present  value  of  future  revenue  method  of 
measuring,  520-524. 

problem  of,  482-484. 

repair  charges  as  a  part  of,  524-525. 

reserves  for,  107. 

revenue  as  a  basis  for  measuring,  500-510. 

sinking  fund  method  of  measuring,  515- 

5i7- 
straight  line  method  of  measuring,  511- 

SiS- 

use  of  valuation  accounts  to  show,  106-107. 
Deterioration,  106,  452. 
Developmental, 

period,  446. 

value,  535. 
Direct  expense,  615. 
Directors  (see  also  "Corporation"). 

importance  of  income  sheet  to,  548. 
Disbursements, 

journal,  85,  87. 

contrasted  with  expense,  225. 
Discount  (see  also  "Interest"). 

account,  133,  282. 

compound,  357. 

on  stock,  295-296. 

rate  of,  355. 

simple,  356. 
Discounting,  355. 
Discounts, 

accounts,  closing  of,  173. 

cash,  71-72,  653-656. 

columns  for,  88-89. 

on  securities,  448-450. 

purchase,  89. 

sales,  88. . 

stock,  22. 

trade,  71. 

treatment  in  statements,  194-195. 
Dissolution     (see     "Partnership,"      "State- 
ments of  insolvency"). 
Dividends, 

account,  144,  302. 

appropriations  of,  300-305. 


Dividends  —  continued 

payable,  319. 

payment  of,  180-190. 

scrip,  303. 

stock,  303-305. 
Donated, 

stock,  285-288. 

surplus,  288,  312. 
Donations, 

significance  of,  45. 
Double-entry  bookkeeping, 

basis  of,  31.  • 

advantage  of,  in  a  single-proprietorship, 

2S4-2SS. 

Drafts,    317     (see    also    "Notes    payable," 
' '  Notes  receivable  ") . 


Economic  cost,  614  (see  also  "Net  revenue"). 
Efficiency,  10  (see  also  "Cost    accounting," 

"  Management ") . 
Embezzlements,  648. 
Enterprise, 

business,  3. 
Endorsements, 

of  notes  receivable,  1 29. , 
Entries    (see    also    "Journal,"     "Journaliz- 
ing"). 

closing  and  adjusting,  56. 

balancing,  158,  168. 
Equity  accounts,  43-47. 

classification  of,  132-150. 

closing  of,  187-191. 
Equation, 

the  fundamental  accounting,  20-24. 
Equities  (see  also  "Accounts,"  "Liabilities," 
"Proprietorship"). 

as  a  class  of  accounting  data,  IQ. 
Examinations  (see  also  "Auditing") . 

bank,  644. 
Expense, 

classification  and  distribution  of,  615-619. 

definition  of,  41. 

indirect  and  direct,  615. 

transactions,  42-43. 
Expense  accounts, 

classes  of,  136-142. 

functional  classification  of,  130-142. 

illustrative  entries  in,  136-137. 

in  municipal  accounting,  624-626. 

railway,  632-635. 

subdivision  of,  42. 
Expense  and  revenue, 

account,  163,  171. 
closing  of,  185. 

statement,  193-197. 
account  form,  194. 
report  form,  195. 


INDEX 


681 


Experimental, 
costs,  230-231. 
value,  535. 


Factory  ledgers,  97. 
Fiduciary  accounting,  421-425. 
Financial  statements,  192-219. 
Finished  goods, 

account,  121,  162. 
closing  the,  160-167. 

valuation  of,  474-477. 
Fixed  assets,  103-120. 

closing  accounts  with,  157-159. 

controlling  accounts  for,  118-119. 

valuation  of,  457-461,  477-481,  483-541. 
Fiscal  period,  155.  ^_ 

Franchise,  116,  529. 
Frequency  of  conversion,  350. 
Fuel  account, 

closing  of,  179. 

Functional    classification    (see    "Balance 
sheet,"  "Cost  accounting"). 

of  fixed  asset  accounts,  117-120. 

of  expense  and*revenue  accounts,  139-142. 
Funds, 

depreciation,  496-500. 

sinking,  372-374,  425-429. 


Gain  (see  also  "Dividends,"  "Profit"). 

definition  of,  45. 
General  expense,  179. 
Going  value,  535-538. 
Goods  in  process, 

account,  121,  161. 
closing  the,  160-167. 

valuation  of,  474-477. 
Goodwill,  1 1 6. 

nature  of,  528-530. 

recognition  of,  277. 

valuation  of,  530-534. 

.     H 

Hatfield,  H.  R.,  10,  335- 
Holding  company,  567. 
Hepburn  Act,  629. 


Improvement  (see  also  "Maintenance"), 
meaning  of  an,  104. 
valuation   of   an,    for   municipal   balance 

sheet,  622. 
Inadequacy,  452. 

Income     (see     "Dividends,"      "Interest," 
"Profit,"  "Proprietorship"). 


Income  bonds,  324-325. 
Income  accounts  (see  also  "Income  sheet," 
"Revenue,  accounts"). 

railway,  635-636. 

Incomtf  sheet,  10,  545-571  (see  also  "State- 
ments"). 

comparative,  555-558. 

consolidated,  567-570. 

municipal,  623-626. 

operating  accounts  classified  in,  558-560, 
563-567- 

purposes  of,  546-549. 

railway,  668,  670. 

report  supplementary  to,  557-558. 

sales  accounts  classified  in,  561. 

significance  of,  193. 

summary,  549-555- 
Indirect  expense,  615. 

methods  of  distributing,  617. 
Insolvency, 

statements  of,  599-605. 
Insurance, 

account,  closing  of,  180. 
Installation  costs,  479. 
Installment  book,  291. 
Intangible  assets,  528-541. 
Interest,  188-189. 

account,  144. 

accruals,  189. 

and  discount,  338,  355. 

on  non-interest  bearing  note,  388-391. 

and  notes  payable, 

entries  involving,  148-149. 

and    notes    receivable,    transactions    in 
volving,  70-71. 

calculations  and  formulae,  349-386. 

commercial,  334-339- 

compound,  350. 

computations,  338-339- 

determining  the  rate  of,  383-386. 

during  construction,  438-446. 

effective  rate  of,  354. 

explicit,  33I-334- 

implicit,  33I-334- 

in  cost  accounting,  613-615. 

in  fiduciary  accounting,  421-425. 

in  relation  to  a  future  sum,  355-356. 

in  valuations,  344-348.! 

nominal  rate  of,  354. 

on  bonds,  341-343- 

on  capital  owned,  as  an  expense,  223. 

rate  of,  350. 

simple,  350. 

tables,  657-667. 

transactions,  387-429. 

Interstate  Commerce  Commission,  119,  555 
(see  also  "Railroad  accounting"). 

classifications  prescribed  by,  119,  629-637. 


682 


INDEX 


Interstate  Commerce  Commission  —  cont. 
expense  and  revenue  classifications  of,  142. 
power  of,   to  have  public  utility   books 

examined,  645. 
rules   in  connection   with   discounts  and 

premiums,  296. 
rules    in    connection    with    maintenance 

charges,  236. 

rules    relating    to    interest     during    con- 
struction, 444. 
Inventories, 

treatment  in  statements,  196. 
Inventory, 

bases  of  valuation  for,  156. 
necessity  for,  154-156. 
perpetual,  156. 
types  of,  156. 
Investment, 
as  a  basis  for  valuation,  461-463. 


Joint  stock  company,  257. 
Journal,  58,  59-61. 

special-column,  77-84. 

stock,  293. 
Journalizing,  64-74. 
Journal  of  Accountancy,  461 . 


Labor, 

account,  closing  the,  178-179. 

cost  data  concerning,  612. 
Land  valuation,  108,  458-461,  480-481. 

for  municipal  balance  sheet,  622. 
Leases,  234,  530-541. 
Ledger,  58,  62-84. 

contrasted  with  journal,  62. 

creditors',  63,  84. 

customers',  62,  83,  97. 

general,  63. 

stock,  291. 

subscription,  290. 
Length  of  life, 

of  assets,  in,  112,  120. 
Liabilities,  23,  313-327  (see  also  "Accounts," 
"Balance    Sheet,"    "Bonds,"    "Eq- 
uities"). 

accrued,  150,  318-319. 

contingent,  129,  320-321. 

current,  47,  147-150. 

deferred,  320. 
Liquid  assets, 

in  balance  sheet,  203-204. 
Liquidity  of  assets,  in,  112. 
Liquidation  (see  "Insolvency"). 
Loss, 

definition  of,  44. 

treatment  of,  190. 


Loss  and  gain, 
account,  133. 


M 


Machinery, 

treatment  of  installation  costs  of,  479. 

valuation  of,  478-479. 

Maintenance,  486  (see  also  "Depreciation," 
"Repairs,"  "Replacement"). 

and  improvement,  contrasted,  234-238. 
Management   (see  also  "Cost  accounting"). 

and  valuation,  455-461. 

problems  of,  609-615. 

statistics  of,  12. 
Manufacturing, 

department,  expense  accounts  for,   139- 
140. 

expense,  in  income  sheet,  559,  566. 

expense  account,  use  of,  186. 
Materials, 

account,  121,  160. 

entries  involving,  122-123. 

returned,  164. 

valuation  of,  474-477. 
Merchandise, 

discounts,  653-656. 

valuation  of,  474-477. 
Merchandise  accounts,  167-174. 

cost,  167. 

mixed,  167-169. 

revenue,  167. 

trading,  172-173. 
Methods, 

of  measuring  depreciation,  506-527. 
Middleditch,  Livingston,  461. 
Misappropriations,  648. 
Mitchell,  W.  C.,  8. 
Montgomery,  R.  H.,  458,  459. 
Moody's  Manual,  597. 
Mortgages,  no  (see  also  "Bonds"). 

types  of,  322-323. 

payable  account,  135,  136. 
Municipal, 

accounting,  620-628. 

balance  sheet,  621-623. 

budget,  626-628. 

income  sheet,  623-626. 

N 

Neglected  discounts  (see  "Cash,  discounts"). 
Net  loss,  44. 
Net  revenue,  44. 

account,  closing  of,  190-191. 

accounts,  143-147. 

effect  of  accruals  upon,  155. 

determination  of,  220-243. 

division  in  income  sheet,  555. 

division  into  economic  shares,  223. 


INDEX 


683 


Net  revenue  —  continued 

figure,  importance  of,  200. 

relation  to  economic  cost,  222-223. 

significance  of,  220-224. 

variations  of,  553. 

Net  revenue  and  surplus  statement,   197- 
201. 

account  form,  198. 

report  form,  198. 
"Net  worth,"  250. 
Notes, 

non-interest  bearing,  387-39*  • 
Notes  payable,  317-318. 

bank,  317. 

entries  involving,  148-149. 
Notes  receivable, 

discounted,  128. 

endorsements,  129. 

entries  involving,  127-128. 

valuation  of,  177,  473- 

O 

Obsolescence,  106,  121,  452. 
Operating, 

and  non-operating  accounts,  241 . 

division  of  income  sheet,  555. 

ratio,  551. 
Operation, 

the  accountant's  conception  of,  24. 
Organization  (see  also  "Construction"). 

costs,  433-436. 

entries  (see  " Capital     stock,"     "Partner 

ship"). 
Original  entry, 

book  of,  61. 
Overburden,  230. 
Ownership,  19  (see  also  "Equities"). 


Partners, 

accounts  of,  257-260,  260-268. 

kinds  of,  256. 
Partnership,  4,  5,  133- 

agreements,  255.. 

closing  entries  for,  276-278. 

dissolution  of,  267-268. 

limited,  256. 

proprietary  accounts,  257-260. 

purpose  of  a,  255. 

unlimited,  256. 
Par  value,  448-449. 
Patents,  116,  234,  529,  538-539- 
Payroll,  178. 
Period, 

importance  of,  454. 
Perpetual  inventory,  454. 
Perpetuities,  274,  327. 
Personal  accounts,  32. 


'etty  cash, 
account,  12$. 
book,  125. 

'ioneering  value,  535. 
'osting,  75-76  (see  also  "Technique"), 
'referred  stock,  272-273. 
'remium, 

on  stock,  133,  282,  296-297. 
on    bonds,    381-383,    405-509    (see    also 

"Amortization,  of  bonds"), 
'resent  value, 

as  a  basis  for  valuations,  451. 
Principal  (see  also  "Interest"). 

accumulation  of,  349-355- 
'reduction, 

large  scale,  as  related  to  accounting,  7. 
nature  of,  as  viewed  by  the  accountant, 

241. 
Profit  (see  also  "Dividends,"  "Net  Revenue," 

"Proprietorship, "  "Surplus") . 
"unrealized,"  242. 
distribution  of  partnership,  258-260. 
Profit  and  loss, 
account,  253. 
accounts,  railway,  636. 
accumulated,  297-300. 
statement,  193. 

Promissory  notes,  no  (see  also  "Notes"). 
Promotion  costs,  535  (see  also  "Organization, 

costs"). 
Property  (see  also  "Assets"), 
accounts,  railway,  630. 
as  a  class  of  accounting  data,  18. 
register,  585. 
types  of,  7-8. 
Proprietorship,    19    (see    also    "Accounts," 

"Equities"), 
accounts  with,  132-134. 
contrasted  with  liabilities,  248-249. 
corporate,  269-312. 
general  explanation  of,  248-249. 
in  the  balance  sheet,  583,  589-590. 
in  the  partnership,  133,  255-260. 
in  the  single-proprietorship,  250-255. 
Purchase,  i 

book,  61,  92. 
discounts,  71-72,  88-89,  315-316  (see  also 

"Discounts"). 

Public  utility  accounting,  629  (see  also 
"Going  value,"  "Railroad  account- 
ing," "Regulation,"  "Valuation"). 


Railroad  accounting,  620-641. 
Real  estate, 

account,  closing  the,  159. 
Realization  (see  "Insolvency"). 
Rebates,  165. 


684 


INDEX 


Receipts, 

and  disbursements,  statement  of,  224-228. 

contrasted  with  revenue,  225. 

journal,  85,  86. 
Receiver  (see  "Insolvency"). 
Refunding, 

of  securities,  400-411. 
Register, 

property,  585. 
Regulation, 

public,  as  related  to  accounting,  9. 

rate,  and  accounting,  638-641. 
Renewals,  484,  487-491. 
Rent, 

account,  closing  of,  180-181. 

accounting  significance  of,  145-146. 

payable,  181. 
Repairs,  485-487. 
Replacement,  104. 

policy  of  treating  depreciation,  488-491 . 
Replacements,  235-236. 
Reserve  (see  also  "Funds,"  "Surplus").    [ 

for  contingencies,  309. 

for  donated  stock,  287,  288. 

for  fire  insurance,  308-309. 

for  improvements,  133. 

for  taxes,  190,  311. 
Reserves, 

in  balance  sheet,  580. 

secret,  236-237,  311. 

valuation,  106-107,  304-310. 
Revenue  (see  also  "Net  revenue"). 

accounts,  39-43,  136,  142. 

definition  of,  39,  41. 

net,  40. 

transactions,  42-43. 
Rights, 

as  assets,  110-116. 
Royalties,  533. 


Sacrifice, 

as  a  basis  for  valuation,  461-463. 
Salaries, 

of  proprietors,  as  expense  charges,    223- 

224 
Sales  slips, 

use  as  customers'  ledger,  97. 
Safes, 

account,  closing  the,  160-167. 

accounts,  162. 

book,  61,  00-92,  99,  101. 

classified  in  income  sheet,  561. 

discounts,   71-72,  88-89  (see  also  "Dis- 
counts"). 

returns,  165. 
Scrip  dividends,  303. 
Secret  reserves,  236-237,  311. 


Securities  (see  also  "Capital   stock,"  "Lia- 
bilities"). 

as  assets,  112-116. 

corporate,  271-276. 

interest  on,  330-348. 

investments  in,  412-420. 

refunding  of,  409-411. 

valuation  of,  177. 
Selling  department, 

expense  accounts  for,  140. 
Selling  expense, 

account,  use  of,  186. 

in  income  sheet,  559-560,  566. 
Services, 

as  assets,  115-116. 
Share, 

of  stock,  271  (see  also  "Stock"). 
Sight  drafts,  317. 

Single-proprietorship,  4, 133,  250-255. 
Single-entry  bookkeeping,  31,  255. 
Sinking  fund, 

appropriations,  305-308. 

assets,  306,  426-427. 

method  of  measuring  depreciation,   515- 
5i7. 

reserve,  133,  428. 
Sinking  funds,  372-374.  425~429- 
Solvency, 

as    determined    in    balance     sheet    com- 
parisons, 578-579. 
Specialized  ledgers,  96-102. 
Sprague,  C.  E.,  20,  452. 
Statements     (see     also     "Balance     sheet," 
"Income  sheet"). 

baknce  sheet,  201-207. 

construction    and    analysis    of    financial, 
545-605. 

deficiency,  603-605. 

fundamental,  10. 

importance  of,  192. 

of  affairs,  509-603. 

of  expense  and  revenue,  193-197. 

of  insolvency,  590-605. 

of  net  revenue  and  surplus,  197-201. 

of  profit  and  loss,  193. 

of  receipts  and  disbursements,  224-228. 

preparation  of,  192-219. 
Standards, 

of  operation,  612. 
Stock  (see  also  "Capital  stock"). 

certificate,  271. 

certificate  book,  293. 

common,  272. 

dividends,  303-305. 

donated,  285-288. 

discount,  22  (see  also  "Discount"). 

journal,  293. 

ledger,  291. 


INDEX 


685 


Stock  —  continued 

preferred,  272-273. 

subscriptions,  282. 

treasury,  287-290. 
Stockholders,  272. 
Stotes  accounting, 

relation  to  cost  accounting,  619. 
Straight  line  method, 

of  measuring  depreciation,  511-515. 
Subscriptions, 

stock,  282. 

ledger,  290. 
Sundry, 

assets  account,  182-183. 

columns,  use  of  (see  "Technique"). 

liabilities  account,  183-184. 
Supplies, 

valuation  of,  474-477. 
Surplus, 

account,  133,  191. 

accounts,  143-147,  294-312. 

accumulated,  247-300. 

appropriations,  201,  300-312. 

donated,  288. 

in  balance  sheet,  580,  621. 

purposes  of  accumulating,  299-300. 

sheet,  550,  554. 

Suspense   items,    579    (see    also    "Deferred, 
charges,"  "Deferred,  credits"). 


Tables, 

interest,  657-667. 
Tangibles, 

current,  120-126. 

fixed,  103-110. 
Taylor,  F.  M.,  248. 
Taxes, 

accounting  significance  of,  145. 

accruals  of,  190,  201. 

during  construction,  445. 

location  in  income  sheet,  552,  560. 

recent,  effect  upon  accounting,  645. 
Technique, 

developments  in  bookkeeping,  77—102. 
Ten-column  statement,  207-215. 
Terminal  company,  321. 
Trade  discount,  71. 
Trademarks,  529,  539. 
Trading, 

accounts,  162-164. 

enterprise,  196.  [195. 

section  of  expense  and  revenue  statement, 
Transactions, 

asset,  65-68. 

asset  and  equity,  68-73. 

classes  of,  20-30,  33. 

effect  upon  asset  and  equity  classes,  25-26. 


Transactions  —  continued 

equity,  73~74- 

essential  nature  of,  22. 

explanation  of,  56. 

mixed,  74. 
Trial  balance, 

adjusted,  219. 

arrangement  of  accounts  in,  154. 

errors  in,  153. 

illustration  of,  152. 

methods  of  preparing,  153. 
Treasury, 

stock,  287-290. 

bonds,  327. 

Trustee  (see  "Fiduciary  accounting"). 
Turnover,  551. 

U 

Uncollectible  accounts,  175-176. 
Underwriting, 

of  stock,  282-283. 

costs,  535. 

Undivided  profits,  133,  298-299. 
Unissued  stock,  283. 
Unit, 

for  valuation  purposes,  485. 

V 

Valuation, 

and  management,  455-461. 

and  price  changes,  461. 

basis  of,  156,  451-469. 

general  significance  of,  451-461. 

in  organization  and  construction  period, 
433-450. 

of  accounts  receivable,  127,  471-473. 

of  assets,  433-454. 

of  bonds,  378-380. 

of  cash,  124,  470-471. 

of  securities,  412-471. 

problem  of,  n. 

relation  to  accounting,  8. 
Valuation  accounts,  23,  47-50,  106-107  (see 
also  "Reserves"). 

in  balance  sheet,  575,  579-580. 

in  ten-column  statement,  210. 
Vouchers, 

payable  register,  93-96. 

use  of,  94. 
Value  (see  also  "Valuation"). 

significance  of  present  value  as  a  basis  for 
valuation,  451. 

types  of  intangible,  535. 

W 

Wages  payable,  178. 
Wasting  assets,  232-234. 
Working  assets,  204. 
Working  sheet,  215-219. 


Printed  in  the  United  States  of  America. 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 

Los  Angeles 
This  book  is  DUE  on  the  last  date  stamped  below. 


UNIVERSITY  OF  GAL   -, 
nc   ui'-  •' 


10  oo  Mi 


Form  L9-32m-8,'58(5876s4)444 


I  library 
Graduate  School  of  Business  Administration 

Urr'  ••^rpT-'-r  t  f  °-i  i  •o.->rnta 
Los  Angeles  24,  California 


UCU-GSM  Library 

HF5625P27p 


UC  SOUTHERN  REGIONAL  LIBRARY  FACILITY 


001  231  995    o 


